One of the great features of exchange-traded funds (ETFs) is that unlike mutual funds, which are priced once per day, you can buy or sell an ETF anytime during the trading day. An unfortunate drawback to this is sometimes the market price may be higher or lower than the net asset value (NAV) of the underlying basket of securities. When the market price is higher than the NAV, it is trading at a premium, and when it is below NAV, it is trading at a discount. Here are some tips for getting the best order execution on your ETF trades.
First, though, let’s see why premiums and discounts happen.
Low volumes. One key reason is the ETF has low trading volume. When this happen you may see fairly large spreads between the bid price, which is the price somebody is willing to buy the ETF, and the ask price, which is the price somebody is willing to sell the ETF.
Liquidity. Another reason is that the underlying securities of the ETF are not very liquid and do not trade very often. In most cases, when pricing an ETF, each of the underlying securities is priced at its last traded price. Where the underlying securities don’t trade very often, the prices used to calculate the NAV can be out of date, and not reflect the current value. This is more likely to happen in very specialized ETFs, or in fixed-income ETFs, where bonds trade over the counter. When this happens, it is the market value that is often a more accurate reflection of the true value.
Foreign markets. A third reason that a premium or discount can occur is where an ETF has significant holdings in European or Asian equities. As is the case of an ETF that holds illiquid securities, the prices used to calculate the NAV of international ETFs may be out of date. This is because these markets are often closed when the North American markets are open. In these situations, assuming you are looking at a large-cap-focused ETF, it is very likely that the market price reflects the out of date NAV.
Here are three ways you can protect against these potential pricing issues:
1. Use limit orders – A limit order is one where you specify the price at which you want to buy or sell a security on an exchange. With an ETF trade, pick a price that you feel is indicative of the true value of the ETF, and use that as your limit. This price will typically be between the bid and ask prices. This ensures that you don’t overpay for an ETF.
2. Avoid trading in the opening or closing minutes of the day – Because these periods tend to be the most active trading times of the day, it may be more difficult for the NAV to be reflective of the price. By trading in periods where things are calmer, it is much more likely that the market price will be much closer to the NAV.
3. Trade international ETFs early in the day – Given that price discrepancies are generally larger when markets are closed, you will want to buy or sell international ETFs while the international markets are still open for trading. Unfortunately Asian markets are closed well before North American markets open, but European markets are open until 11:30 EST. If you can, try to place orders for international ETFs between 10 am and 11 am EST.
The ability to buy and sell ETFs at any point during the day is one of their more attractive features. It can also be a source of short-term price distortions. By talking some basic precautions, the likelihood of being hurt by any of these price distortions can be minimized.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that a fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. This article is for information purposes only and is not intended as personalized investment advice.