How does the market price ETFs?

Digging into the numbers

If you follow your investments closely, it’s important to understand the variety of prices and values listed for exchange traded funds (ETFs). Here’s an explanation of what these terms mean.

Exchange traded funds (ETFs) are funds that trade like individual securities. As with mutual funds, they “wrap” an underlying basket of assets such as stocks, bonds or commodities. And like stocks, their shares trade on an exchange.

As with stocks, the most important indication of an ETF’s value is its market price – the price at which investors are currently willing to sell or buy ETFs. For ETFs, like stocks, the current market price reflects the highest price at which buyers are willing to buy and the lowest price at which sellers are willing to sell. In other words, the current market price is set by supply and demand.

Because ETFs are diversified across a broad market or market sectors, investors may value them using a different set of measures than they do for single stocks. If you’re investing in company stocks, you may look at data such as the price-to-earnings ratio and dividend yield to get a sense of whether its current market price reflects fair value. While these measures can also be applied to ETFs, they may be less relevant in calculating its value.

Information richness and transparency can be especially attractive for those who trade frequently or otherwise follow the markets closely.

Instead, ETFs investors typically look to a variety of indicative measures. While these are not “prices” at which an investor can always transact, they are useful to gauge how other investors and market participants might value the ETF. Information richness and transparency can be especially attractive for those who trade frequently or otherwise follow the markets closely.

ETF pricing: Bid and Ask price

ETFs, like stocks, have a bid and ask price. The bid price is the highest price other investors are currently offering to buy shares, and the ask price is the lowest price other investors are currently offering to sell shares. The difference between the two, known as the bid/ask spread, is a measure of the costs of transacting in the ETF shares (narrow spreads equate to lower costs).

Portfolio pricing: Net asset value

As with mutual funds, an ETF calculates net asset value (NAV) at the end of each day. It reflects the total per-share value of the underlying securities, plus cash and any other assets held in the portfolio, and less liabilities. For mutual fund investors, the NAV is the final price – what you’ll pay or receive to buy or sell shares of the fund.

In an ETF, the net asset value is used for share creations by an authorized participant, a specialized market maker. Other investors use the NAV as the most recent estimate of the value of the ETF’s shares by the ETF’s sponsor. Because net asset value is calculated only at the end of each day and is based on the information available at that time, the NAV (unlike market price and bid and ask price) is always stale once it has been published.

Why would an ETF trade at a different price from its underlying assets?

ETF prices tend to closely reflect their fair value. That’s particularly the case for funds that track large-cap US stocks, which tend to be highly liquid and trade in the same time zone as the ETF.

That said, an ETF’s price and net asset value will frequently differ – that is, the exchange traded fund will trade above its NAV (at a premium) or below it (at a discount). Here are some common reasons for the ETF premium and discount:

  • When the ETF holds securities that do not trade at the same time as the fund itself, there will be timing differences between the values used to calculate NAV and the market price. This is very common with ETFs that hold non-US stocks, but also affects bond ETFs (because the most recent trade for certain bonds in the portfolios may not be near the market close).
  • A bond ETF values bonds at the bid, while the secondary market may value the ETF shares at the bid, the ask, or somewhere between. This is one reason small premiums are common for bond ETFs.
  • The market price is based on supply and demand. Sometimes there is more of one than the other, causing a premium or discount. This is usually temporary but during periods of market volatility, gaps between the prices at which buyers are willing to buy and the prices at which sellers want to sell can widen until a new price equilibrium is established. (See “Do ETFs add market volatility?”)

It’s important to note that premiums and discounts are less relevant if your ETF is part of a buy-and-hold strategy.

A rich communications tool

For many investors, the market’s ability to price ETFs throughout the day is one of the reasons these vehicles have become such popular portfolio tools. Real-time trading provides the means to quickly express market views and gather insights on market-moving events.

Perhaps even more significantly, during periods of market volatility or illiquidity, ETFs allow all investors to find a price at which transactions in the ETF’s underlying basket of securities can occur. This process of price discovery helps make the markets more liquid, by restoring the balance of supply and demand.

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