Morningstar - Q2 2020 - 49

SCAN TRIGGER
L AU N C H C O M PA N I O N V I D E O

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To be clear, these funds were not alone-
abnormally large premiums and discounts have
been pervasive. In one extreme case, VanEck
Vectors High-Yield Municipal ETF HYD closed
at a 19.3 discount to its NAV on March 12. But
I chose to highlight these three because

income markets. BND is the ETF share class of
the world's largest bond fund. These are not
the funds that anyone-me included-would
have expected to behave as they have in
stressed markets.
What are investors to make of all of this? How
should they respond? Before I dive into the
details, I think it is worth revisiting the basics of
ETF premiums and discounts.
NAV and iNAV
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, and cash. If
the fund uses physical replication to track
its benchmark (that is, it owns securities, not
derivatives), the assets are the component
securities (or a sampling thereof) of its benchmark
index, any accrued income generated through
securities lending, and some cash. Liabilities
for ETFs and other funds will largely consist of fees
owed to the fund company. An ETF's NAV
per share can then be calculated by dividing
the total NAV of the fund by its number of
outstanding shares.

helps make purchases of traditional funds simple
and typically fair.
ETF
.
throughout the trading day and purchased or sold
at the prevailing market price. Thus, a regular
intraday measure of these funds' NAV can
be (somewhat) useful in gauging what (some)
portfolios are worth during the trading day.
This in turn can help investors see whether 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 trading day. However,
unlike traditional open-end mutual funds,
ETF investors trading during market hours will not
transact at the most recent iNAV (which is
mostly symbolic, a touchstone of sorts). Instead,
ETF investors will likely execute their trades
at a premium or discount to a fund's true value.
Premiums and Discounts
ETFs' market prices will generally not track their
NAV nor market makers' own estimate of
their value 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 50.49 for a fund whose component
securities are worth 49.99 in aggregate will
inherently harm your expected returns. When the
market price is lower than the current value
of the portfolio, the ETF is trading at a discount,
which helps buyers and harms sellers. Paying
49.99 for a share in a fund whose component
securities are worth 50.49 could only improve your
expected returns.
Luckily, ETFs typically trade at prices that are
very close to their 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 authorized

EXHIBIT 1

Anatomy of an Arbitrage This hypothetical example illustrates how market makers
keep market price near NAV.
Premium/Discount %

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

0.5
0.4

Traditional open-end mutual funds calculate their
NAV once per business day, after most exchanges
have closed and third-party pricing services
have disseminated up-to-date price information for
various securities. Funds use that value as
the price for new purchase or redemption orders
placed throughout the day. New investors will
purchase fund shares at end-of-day NAV (less any
fees), and investors exiting funds will also do
so at end-of-day 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,

0.3
Transaction cost and compensation
for risk threshold

0.2
0.1

New ETF shares created,
bringing price back to NAV

9:30
Time

10:00

10:30

11:00

0
-0.1
11:30

12:00

12:30

13:00

13:30

Source: Morningstar.

morningstar.com/lp/magazine

Number of ETFs

49

300
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Morningstar - Q2 2020

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