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Exchange traded funds (ETFs) are portfolio-based assets typically organized around a specific investment goal. Investors invest in ETFs by purchasing shares of the portfolio on public exchanges. When the listed share price of an ETF dips significantly below the portfolio’s net asset value (NAV), the fund is at a “discount.” This is generally a good opportunity to buy the fund, since its administrators will typically respond to a discount by reducing the number of shares in circulation to bring the price back up. Here’s what you need to know.
If you want to add ETFs and other investments to your portfolio, a financial advisor can help you develop a strategy to maximize returns.
ETFs are portfolio-based investment products. Each fund holds a collection of assets typically arranged around a specific theme or financial goal. For example, an ETF might invest in the technology sector by holding industry stocks, or it might invest exclusively in high-yield bonds. Investors buy shares of an ETF and can receive yields, dividends and other returns on a basis proportional to their ownership.
Shares in an ETF are sold on public exchanges like the New York Stock Exchange (NYSE). They are highly liquid assets that can be bought and sold as freely as shares of stock.
The value of an ETF is based on its overall collection of assets. This allows funds to invest in more growth-oriented products like stocks while the fund’s inherent diversity offers a measure of stability. An investor will not collect the outsized gains of a single high-performing stock, for example, since lower-performing assets will weigh the portfolio down. Nor will they suffer the losses of a single crashing stock due to the returns of higher-performing assets.
An investor researching how ETF discounts affect trades.
Due to its nature as a portfolio asset, an ETF operates much like a mutual fund. Both investment vehicles are measured based on net asset value (NAV). This is the total value of assets represented by each share in the fund. It is measured as the combined value of all assets the portfolio owns, less any liabilities, divided by the fund’s number of shares.
However, while a mutual fund’s share value is largely determined by its NAV, an ETF’s share value is determined by share price. Since an ETF is a liquid, market-traded product, that share price can fluctuate in real time based largely on supply and demand. Greater demand relative to the existing supply of an ETFs shares will drive the price up. Falling demand relative to the existing supply of an ETFs shares will drive the price down.
Due to this liquidity, an ETF’s share price can relatively easily move off of its NAV. If heavy buying drives an ETF’s share price significantly above its NAV, the fund is trading for more than it is worth. This is known as a premium.
If heavy selling drives an ETF’s share price significantly below its NAV, the fund is trading for less than it is worth. This is known as a discount.
For example, say that ABC Fund has issued 8,000 shares. It holds the following assets:
1,000 shares of stock at $10 per share
500 shares of stock at $20 per share
1,500 shares of stock at $15 per share
In this case, ABC Fund would have a net asset value of $53.12. (Total assets = $10 *1,000 + $20 * 500 + $15 * 1,500 = $42,500 / 8,000 shares)
If ABC Fund currently trades for $53 per share, the fund would be considered fairly priced since its share price is close to its net asset value. However, say that trading drops for ABC Fund, driving its share price down to $45. In this case, ABC Fund is trading at a 16% discount.
When an ETF trades at either a premium or a discount, the administrator will typically attempt to bring the fund’s share price back in line with the NAV. This is done through either creation or redemption.
When an ETF trades at a premium, the administrator will create new shares and issue them to market participants. This helps reduce the market price by increasing supply relative to the demand.
When an ETF trades at a discount, the administrator will redeem shares by collecting them from market participants. This takes shares out of circulation, helping to raise the market price by reducing supply relative to the demand.
For investors, this can create an opportunity. Every publicly traded ETF will publish its NAV, typically calculated daily at the close of the market. Investors who see that an ETF has begun trading at a discount, or who see a fund’s underlying assets moving toward discount rates before the close of trading, can buy into the fund. It is likely that the fund administrators will redeem shares to raise the price, making this a good opportunity to buy.
An investor reviewing her investment portfolio.
When an ETF’s share price is significantly lower than its net asset value, this is known as trading at a “discount.” When this happens the ETF will typically attempt to raise the share price through the redemption process, removing shares from circulation to reduce the supply relative to demand.
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