ETF Premium/Discount — When the Market Price Diverges from NAV

An ETF has two prices. One is the "market price" at which it is bought and sold on the exchange, and the other is the "net asset value (NAV)," the actual value of the assets the ETF holds.

It would be nice if the two were exactly equal, but in reality they diverge slightly. When the market price is above NAV it is called a premium, and when it is below it is called a discount, and that difference is the premium/discount. Buying at a premium means you bought for more than the asset value, a loss by that much.

The reason the premium/discount does not persist for long is the arbitrage of authorized participants (APs).

When an ETF trades at a premium (expensive), an AP gathers the underlying assets, creates new ETF units (creation), and sells them to the market to profit. Supply increases and the market price comes down toward NAV.

Conversely, when it trades at a discount (cheap), an AP buys the cheap ETF and redeems it (redemption) for the underlying assets to profit. ETF supply decreases and the market price rises toward NAV.

Arbitrage is not always perfect. In several situations, the premium/discount can grow noticeably and persist.

First, when the market swings extremely, APs find it hard to carry out arbitrage smoothly, so the gap widens.

Second, an ETF holding overseas assets cannot immediately access its underlying assets during hours when the local market is closed, so a divergence arises equal to the time difference.

Third, a thinly traded ETF has weak arbitrage incentives to begin with, so its premium/discount can be large. So when buying an ETF, it is safer to avoid moments when the premium/discount is large (especially right after the open or during a volatility spike).