Spreads, Pricing Relative To NAV, And Costs

The primary factors affecting ETF bid ask spreads are the liquidity and the market structure of the underlying securities.

• Spreads on fixed income ETFs tend to be larger than those for large cap equity ETFs.
• When ETFs and underlying securities trade in different markets and time zones, the spreads are narrower during the overlapping time period when both markets are open. Specialized ETFs, such as those that track commodities, volatility futures, or small- cap stocks, tend to have wider spreads. Thinly traded ETFs, regardless of the liquidity of the underlying, also command a higher spread.

A market maker can offset an ETF transaction either with another counterparty in the secondary market or via the creation/redemption process in the primary market. Quoted spreads depend on whether the dealer is reasonably assured of completing an offsetting trade in the near future in the secondary market. APs can also undertake redemption/creation transactions in the primary market.

maximum spread =

creation/redemption fees plus other trading costs

• spread of the underlying securities
• risk premium for carrying the trade until close of trading
• AP’s normal profit margin

− discount based on probability of offsetting the trade in secondary market

Note that the posted bid ask prices are for smaller order sizes, while larger trades are best handled via negotiation. For larger trades, the negotiated spreads vary based on liquidity conditions and volatility in the market. Spreads widen during volatile times or when significant new information is expected to be released to the market.

The NAV of an ETF is generally its fair value. If the ETF and the underlying securities trade on the same exchange, all closing prices are contemporaneously determined and any timing related noise in pricing is eliminated. Exchanges publish intraday indicated NAVs (iNAVs), which are the fair value estimates during the trading day.

An ETF trading at a price above (below) NAV is said to be trading at a premium (discount). The premium or discount is calculated as a proportion of the NAV.

Using closing prices:

ETF premium (discount) % = (ETF price − NAV per share) / NAV per share

Sources of premiums or discounts include the following:

• Timing differences. ETFs on foreign securities may experience gaps between the time the ETF is traded and the time when the underlying trades in a foreign market. These timing differences can cause a discrepancy between the NAV and the ETF’s trading price.
• NAV may be based on the market’s estimate of what those foreign securities would trade at if their local market was still open. Similarly, OTC bonds that do not trade on an exchange will not have a true closing price; hence, the price of an ETF that comprises such bonds may not be equal to estimated NAV. Fair value estimates of nontraded bonds are often determined by pricing services that may base fair value estimates on bid prices of comparable bonds.
• If these bid prices are low due to higher dealer risk of carrying those bonds in inventory, the closing ETF price would be higher than the NAV based on these fair value estimates. Stale pricing. Infrequently traded ETFs may reflect noncurrent prices and, therefore, their value may differ from NAV.
• Suppose the last ETF trade occurred at 2:00 pm ET and the markets (for the ETF and the underlying) closed at 4:00 pm ET. The NAV calculated based on the closing prices of the underlying may differ from the stale price (i.e., the 2:00 pm price) of the ETF.

ETF prices may be more informative than NAV or iNAV when (1) the market for the underlying is closed, (2) underlying securities are highly volatile or illiquid, or (3) there is a time lag between the pricing of the ETF and the pricing of underlying.

ETF costs include management fees and trading costs. Because the market for ETF providers is highly competitive, and because ETFs are passively managed, management fees for ETFs tend to be lower than those for mutual funds.

Trading costs include brokerage or commission fees and bid ask spreads. Additionally, larger orders may incur price impact costs depending on the liquidity of the secondary market. The premium/discount relative to NAV can be another hidden part of the trading cost (that is realized if the said premium/discount reverses over the holding period).

The portfolio turnover of ETFs results in an implicit cost which acts as a drag on returns for the investor. ETFs that track stable indices will have lower portfolio turnover cost; this cost is negligible for most ETFs.

Because trading costs are only incurred at the time of the transaction, annualized trading cost diminishes over a longer holding period. For investors that trade frequently, the spread and commission (part of trading cost) are far more important components of the total cost. For long term, buy and hold investors, management fees are a more important component of the cost:

total cost = round trip trading cost + management fees

round trip trading cost = round trip commission + spread