Premiums-Discounts and Exchange Traded Funds

Abstract

Closed-end mutual funds present a long-standing puzzle for financial economists because they so commonly trade at substantial discounts to their net asset value (NAV) (or occasionally, premiums), thus violating the “law of one price.” Open-end funds do not have this problem because their investors are always able to sell or redeem shares at NAV. The growing population of exchange-traded funds (ETFs) fall somewhere in between: most investors acquire or liquidate ETF holdings by trading them in the market, which allows deviations between prices and NAVs. But ETFs may also be redeemed or created by deposit or withdrawal of actual shares, which tends to eliminate long-run differences between market prices and NAVs. Yet apparent differences, sometimes substantial ones, do exist. These may be partly spurious though—for example, if some of the transactions prices used in calculating NAV are stale or subject to bid-ask bounce. This article addresses the issue in the context of an errors-in-variables model, in which different potential sources of pricing errors are modeled explicitly. For some ETFs, the existence of a futures market on the same underlying index provides an additional source of information about true NAV. By contrast, NAVs for international ETFs may be based on prices for stocks in foreign markets that are closed when the ETF is trading in the U.S. Engle and Sarkar show that much of the apparent premium or discount between ETF market prices and NAVs can be explained by measurement errors, and that these are smaller and more quickly reversed for domestic ETFs—especially those with associated futures trading—than for international ETFs.