If you’ve researched exchange traded funds (ETF), you’ve noted that one of the advantages is the fact that an ETF trades throughout the day like stocks, instead of trading only after market close like mutual funds. Yet if you haven’t purchased an ETF you may be surprised to find that your price is higher or lower than the underlying value of the shares in the ETF.
Net asset value
Net asset value (NAV) is essentially the value of the investments within a fund. One similarity between mutual funds and ETFs is that both calculate their NAV at 4pm, after markets close. Mutual funds set their price at this point. However, ETFs may be updated through an intra-day NAV several times per minute during the trading day.
Market price
ETFs trade at a market price that is based on the NAV but may differ due to supply and demand. In other words, when you buy an ETF you may be paying a premium or receiving a discount based on the most recent NAV. This results from more people wanting to purchase an ETF at the same time (increased demand) or people moving out of an ETF (increased supply).
Arbitrage
Even though the price may not correspond directly to the NAV, the difference will be relatively minor most of the time. This is due to arbitrage. When the ETF price is higher than the NAV, people will move in to sell the overpriced ETF and buy the underlying securities, making a premium on their transaction. If the price is lower, they would buy the ETF and sell the underlying securities. The is essentially a risk-free move and is done with thousands of shares so even smaller discrepancies can be of value to arbitragers.
Best times to trade
If you’re researching ETFs, you may notice that spreads are widest just after markets open and before they close. This is mainly due to the fact that some of the fund’s underlying securities may not be trading right at market open, and as trading closes trades may not be fulfilled. Avoiding these times can help ensure the market price and NAV are more closely aligned.