Terms of the Trade: NAV, Premiums, and Discounts

Deciphering the deluge of terms and acronyms that has accompanied the emergence of the ETF marketplace

Ben Johnson 6 May, 2010 | 3:57PM
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The emergence of the ETF marketplace has been accompanied by a deluge of different terms and acronyms that have left many investors (ourselves included) in want of a user's manual. With our body of work on the ETF Centre, we aim to piece together exactly such a resource over time to help investors use exchange-traded funds to their best advantage. Here, we will discuss net asset value (NAV): what it is, why it matters, and how to make sure you are buying shares of an ETF at a fair price.

What is NAV?
Net asset value is the total value of an ETF's assets, less the total value of its liabilities. The composition of an ETF's assets will vary, but it generally consists of stocks, bonds, or other collateral. If the fund uses physical replication to track its benchmark, the assets are the component securities (or a sampling thereof) of its benchmark index, any accrued income generated through securities lending, and some cash. If the fund uses synthetic replication (or total return swaps) to track its benchmark, then its assets will include a basket of pledged collateral securities—which may bear little resemblance to the benchmark index—any unrealised gains on the total return swap providing exposure to the index, and cash.

Liabilities for ETFs and other funds will largely consist of fees owed to the fund company, and any unrealised losses on total return swaps (which applies solely to swap-based ETFs). An ETF's NAV per share can then be calculated by dividing the total net asset value of a fund by its number of outstanding shares.

NAV = (Total Value of Assets - Total Value of Liabilities) ÷ Number of Shares

What is iNAV?
Common funds calculate their NAV once per business day, after most exchanges have closed, and use that as the price for orders placed throughout the day. New investors will purchase fund shares at NAV (less any fees) and those exiting funds will also do so at NAV (again less any fees). This single price for purchases and sales, set using end-of-day prices for all the assets in the portfolio, helps make purchases of traditional funds simple and typically fair.

Exchange-traded funds offer intraday liquidity as expressed in a market price. Thus a regular intraday measure of these funds’ NAV is needed to see what the portfolio is worth during the trading day, and to help investors see if they are paying or receiving a fair price. This intraday portfolio value is called the fund’s indicative net asset value or iNAV. The iNAV is calculated at regular intervals (usually every 15 seconds) throughout the course of the trading day, and helps market makers keep prices close to the portfolio value. However, unlike regular funds, ETF investors trading during market hours will typically have to execute their trade at a slight premium or discount to a fund’s iNAV.

Premiums and Discounts
ETFs market prices will generally not track their NAV in lockstep. If a fund's market price is higher than its NAV, it is said to be trading at a premium, which is good for sellers and bad for buyers. Paying 101p for a fund whose component securities are worth 100p in aggregate will inherently harm your expected returns. When the market price is lower than the NAV, the ETF is trading at a discount, which helps buyers and harms sellers. Paying 99p for a share in a fund whose components are worth 100p could only improve your expected returns.

Luckily, ETFs typically trade at prices that are very close to NAV. Even the examples above, of a 1% premium or discount, would be an exaggeration for nearly all ETFs. This is because any premium or discount that arises presents an arbitrage opportunity for market makers—which are also referred to as authorised participants. Market makers are able to freely create and redeem ETF shares by exchanging a pre-determined basket of securities or other collateral for new ETF shares and vice versa. They can effectively buy or sell shares of an ETF for their net asset value at the end of the day. If an ETF's market price strays too far from its NAV, market makers will move to profit from the relative mispricing between the fund's market price and the aggregate price of its underlying securities.

For example, if the component securities of a given index are worth 100p per ETF share and the ETF’s shares are changing hands for 101p each, a market maker can deliver that basket of securities to the ETF provider in exchange for new ETF shares and subsequently sell the new ETF shares on the open market. The market maker will pocket a small profit for its effort (which will likely be less than 1p per ETF share given the costs involved in this process). As market makers compete for these opportunities to make a quick low-risk profit they serve to minimise the size and persistence of premiums and discounts for the fund’s shares.

Examples of Persistent Premiums and Discounts
There have been instances that prove premiums or discounts can persist (at least temporarily) for ETFs. For example, during the darkest days of the 2008-2009 market meltdown, premiums for some fixed income ETFs showed some staying power. During this period some fixed income ETFs became a source of liquidity for holders of these funds’ underlying securities, who had almost no way to sell individual bonds on the market. For example, based on daily data collected by Morningstar, the iShares Corporate Bond ETF traded at a persistent premium to NAV (see the chart below) for the period spanning from the Lehman Brother's bankruptcy in September of 2008 through early 2009. During this timespan, the average daily premium was 2.3%.

How Can Investors Monitor and Manage Premiums and Discounts?
There is not much that investors can do to manage the inevitable premiums and discounts to NAV that exist in the ETF market. Fortunately, the discrepancies tend to be fairly small, thanks to the hard work of arbitraging market makers, so this should not be a major concern for most long-term investors.

However, it may be worth a quick look to check that your buying or selling price is close to NAV. Although most fund companies do not make their iNAV freely available, the bid and ask quotes offered on the market and viewable through most brokerages provides the next best thing. At any given time, market makers and other investors place their bid and ask prices on either side of their estimate for the fund’s fair value. If the bid and ask quotes are only a few pennies apart, you simply take the midpoint of the two numbers to get a great approximation of the NAV at that time.

For those that insist upon trading as closely to NAV as possible, there are some options. For instance, db x-trackers offers a facility to banks and brokers that are clients of Deutsche Bank Global Markets that allows them to trade at the official end-of-day NAV for ETFs listed on the London Stock Exchange. The minimum transaction size is one share and fees range from 0.03% to 0.30%, depending on the fund involved (funds tracking smaller or less liquid indices will charge higher fees). This option could ultimately save cost-conscious investors a few basis points in transaction expenses. We would expect that programmes such as these will grow in number as ETFs continue to see more widespread use.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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