ALL ABOUT ETFs: PREMIUMS AND DISCOUNTS

Exchange traded funds (ETFs) have become indispensable tools for investing in financial markets. While there are many ways to evaluate ETF performance, one measure—an ETF’s premium or discount—can be more nuanced than the others.

ETFs combine many of the features of mutual funds and stocks. Like mutual funds, ETFs are pooled investment vehicles that offer access to a broad mix of stocks, bonds, or other assets. Unlike mutual funds, most ETF investors don’t interact directly with the fund provider when buying or selling fund shares. Instead, they generally trade existing ETF shares with each other during market hours, on an exchange, just like trading stocks.

Most ETF trading activity happens on exchange, or in the “secondary” market, where investors buy and sell existing ETF shares. As with stocks, the price of the shares is determined in real-time. A separate, “primary” market exists where large financial institutions, called “authorized participants” (APs), transact with ETF issuers to create or redeem ETF shares based on market demand.

An ETF’s market price is typically in-line with the value of its underlying securities or assets, but it’s possible for an ETF to trade at a price above (premium) or below (discount) the current value of its assets. If the price of an ETF share is greater than the value of its underlying securities or assets, the ETF is said to be trading at a “premium.” In response, APs may buy the ETF’s underlying securities and exchange them with an ETF issuer in return for newly created ETF shares, which may then be sold in the market for a profit.¹ Likewise, if the market price of the ETF falls below the value of its underlying securities (the ETF is trading at a “discount”), an AP could buy shares of the ETF and redeem them with the ETF issuer in exchange for the ETF’s underlying securities or cash.

This “arbitrage mechanism” generally helps keep the price of an ETF share in line with the value of its basket of underlying securities or assets. However, evolving market conditions can result in large or persistent ETF premiums and discounts. Premiums and discounts can also arise from a “timing mismatch” between when an ETF’s net asset value (NAV) is calculated and when the trading window for the ETF closes.

While some premiums and discounts present actionable arbitrage opportunities, where APs have an economic incentive to create or redeem ETF shares, others may simply be “optical” discounts.² In these instances, there could be a timing mismatch (as described above), or the ETF could be providing price discovery, reflecting the real-time value of its underlying securities or assets.

ETF premiums and discounts can provide valuable information to investors who are assessing the cost of an ETF relative to other market access vehicles. However, it’s important to understand what is behind a reported premium or discount.

A closer look at the impact of timing mismatches on ETF premiums and discounts

Certain asset classes, like commodities and international equities, may experience premiums or discounts related to the timing of the prices used to calculate the ETF’s NAV. Because ETFs trade on exchanges, their final daily market price is generally determined by the official closing price of the ETF shares at market close (typically at 4pm ET). While the market price of the ETF is generally based on its price at the time its respective exchange closes, the ETF’s underlying assets may be valued using prices struck at a different time.

For example, the NAVs of both the iShares Gold Trust (IAU) and iShares Silver Trust (SLV) are calculated based on the London Bullion Market Association (LBMA) Gold and Silver Prices, respectively. These prices are struck at 10am and 7am ET, respectively—well in advance of the 4pm ET U.S. market close.³ Because the ETF can continue to trade until the U.S. market closes, any demand to buy or sell shares of the ETF will likely cause the exchange price of that ETF to deviate from the price used at the time the NAV was calculated, creating an optical premium or discount.

Another example is U.S.-listed ETFs that hold international equities where the ETF will continue to trade even when the local markets for its underlying securities are closed. Some ETF providers, such as BlackRock, apply fair-value adjustment methods when determining the NAV of ETFs that have international equities. This often results in more precise pricing for the NAV but may result in premiums or discounts that look different than the premiums or discounts of ETFs that do not make these adjustments.

The launch of spot bitcoin ETFs in the U.S. in January 2024 added another dimension to evaluating ETF premiums and discounts, as bitcoin trades 24/7 and does not have an official closing price. This means that issuers of spot bitcoin ETFs may each use a unique methodology to calculate the NAV of their ETF. For example, the iShares Bitcoin Trust (IBIT) calculates daily NAV using the volume-weighted average price (VWAP) of bitcoin over multiple crypto exchanges between 3pm and 4pm ET, while other ETFs may use the price of bitcoin at 4pm ET. Because IBIT uses an average price to calculate daily NAV, major changes in the price of bitcoin towards the end of the trading day can manifest in a larger premium or discount. Additionally, these different methodologies can result in seemingly similar funds exhibiting different premium and discount behavior, based on their respective NAV calculations. Note that IBIT, IAU and SLV are not investment companies registered under the Investment Company Act of 1940, and therefore are not subject to the same regulatory requirements as mutual funds or ETFs registered under the Investment Company Act of 1940.

We summarize some of these differences in NAV calculation methodologies below (Figure 1).

The emergence of ETF premiums and discounts can simply be a result of the different methodologies used to determine the calculation of an ETF’s NAV. When evaluating ETF premiums and discounts, it’s important to understand the methodology used to determine whether there is a “true” deviation from the value of an ETF’s underlying securities, or just an optical one.