New Study Examines Domestic, International ETF Premiums and Discounts By John Spence February 14, 2002

Unlike traditional open-ended mutual funds, exchange-traded funds are priced continuously throughout the day, and sometimes premiums and discounts arise relative to the net asset value (NAV) of the underlying portfolio. Many cautious investors have cited the potential for premiums and discounts as one of the major drawbacks of ETFs, and so far there hasn't been a lot published on the issue.

The American Stock Exchange, which played an integral role in bringing the first ETF to market and is home to a vast majority of domestic ETFs, recently commissioned the Analysis Group/Economics to conduct a comprehensive analysis of domestic and international ETF premiums and discounts. The study was conducted by Dr. Robert F. Engle of NYU and Dr. Debo Sarkar of the Analysis Group/Economics. They examined 21 highly traded domestic ETFs and 16 of the country basket iShares.

To calculate premiums and discounts, the authors of the study compared the midpoint of the bid/ask price to the ETF's NAV, and found that the standard deviation of premium is small relative to the bid/ask spread. For the end-of-day, the bid/ask spread ranges from 10 to 80 basis points (0.10%-0.80%), while the standard deviation of premium ranges from 10 to 35 basis points. The largest premiums showed up at the end of the trading day, while premiums during the day were relatively small, and larger premiums and discounts during the day disappeared after five to ten minutes.

However, there is a perfectly logical reason for outsized premiums and discounts at the end of the trading day. The NAV of the ETF is calculated at 4:00 p.m. Eastern Time each day, but some ETFs continue trading until 4:15 p.m. Obviously, comparing price and NAV from different times can skew ETF premiums and discounts. To correct for this timing discrepancy, the authors came up with a model that took into account futures prices from 4:00 to 4:15. Using this model, the premium standard deviation shrinks to a range of 9 to 24 basis points.

For the international ETFs, the standard deviation of premium is likewise small relative to the bid/ask spread. For the end-of-day, the bid/ask spread ranges from 80 to 220 points, while the standard deviation of premium ranges from 50 to 100 basis points. Not surprisingly, the authors found that international ETFs exhibit greater and more persistent premiums and discounts than their domestic counterparts.

However, generally speaking, large NAV discrepancies may arise in international ETFs because many times stale or dated prices are being used. Taking the MSCI Japan iShares as an example, comparing the 4:00 p.m. Eastern Time NAV to the closing price of the fund may not be accurate. The reason is that the Japanese stocks in the fund were last priced when the stock exchange in Tokyo closed, approximately 16 hours earlier.

Complicating matters, the authors of the study also found that international ETF quotes are on average revised only once an hour, and the median interval between trades is 25 minutes. They also found that it took several hours, and in the extreme several days, for larger premiums to disappear in international ETFs.