ETF A has an average premium of 18 basis points (0.18 percentage point), and ETF B has an average premium of 0 basis points. An investor looking at those averages might assume ETF B is a better product.
This would be incorrect.
Although ETF A does have a larger average premium, the premium is more stable, which reduces the investor’s risk and potential costs. If investors buy and sell at a stable premium, the cost is likely to be predictable and relatively modest. As the graph illustrates, an investor might buy ETF A at a premium of 22 basis points and sell at a premium of 18 basis points, incurring only 4 basis points of round-trip transactions costs. While it may seem a disadvantage to buy an ETF at a premium of 22 basis points, selling at a similar premium can offset this initial cost.
Conversely, ETF B has a smaller but more volatile premium, which exposes investors to the possibility of buying at a significant premium and selling at a significant discount. An investor who purchased at a premium of 64 basis points and sold at a discount of 61 basis points would incur 125 basis points (1.25 percentage points) of round-trip transaction costs. Selling at a steep discount only adds to the initial transaction cost.
Again, a larger but stable premium is often preferable to a lesser, volatile one. The standard deviation of historical premiums is arguably a clearer way to estimate transaction costs than the average premium.
It’s also worth noting that any ETF premium or discount published at the end of a trading day generally represents only the closing snapshot, comparing the ETF’s NAV to its closing price on its primary exchange. A premium or discount at the close may not accurately depict where the ETF traded relative to its NAV during the trading day.
Differences in ETF premiums and discounts across asset classes
Domestic ETFs
Domestic equity ETFs generally trade in line with their NAVs. Premiums and discounts are typically slight for a variety of reasons, including the lower cost of buying and selling the underlying domestic equities, the relative ease of pricing underlying stocks and ETFs simultaneously, and the lower fixed fees incurred.
In other words, pricing domestic ETFs is relatively straightforward and can frequently be achieved without too much deviation from NAV.
International ETFs
International ETFs may have more pronounced premiums and discounts. It’s more challenging to determine the fair value of the underlying constituents, partly because the markets where they’re listed may not be open during hours when U.S.-listed ETFs are trading.
Other costs may include larger fixed fees, higher commissions, stamp taxes and associated fees, foreign exchange hedging costs, and the imprecise nature of fair value factors. This makes the process to create or redeem international ETFs less precise, which translates to larger premiums and discounts.
Fixed income ETFs
Fixed Income ETFs usually trade at inherent premiums. Their NAVs are based on the bid prices of all their underlying securities, or the prices at which the funds could sell all of their holdings.
A fixed income ETF’s market price will typically be near the midpoint of all the underlying bonds in the ETF’s basket. This represents what it would cost market makers to buy the underlying bonds to create new ETF shares, though sometimes an ETF can trade up toward the cost to create new shares.
Key takeaways
Premiums and discounts are important components of the total cost of ETF ownership, and they vary by asset class. Their stability can be considerably more meaningful than their size. A larger, but stable, premium is often preferable to a lesser, volatile one.
While the existence of premiums and discounts should not lead investors to avoid ETFs, extremely volatile premiums and discounts can erode longer-term returns significantly. Investors can steer clear of relatively elevated ETF premiums and discounts by avoiding trading on days when markets are roiled. In any case, they should understand good ETF trading practices.
