An ETF typically trades at a price that's close to the net asset value, or NAV, of its underlying securities. However, due to factors such as trading hours and market liquidity, an ETF’s market price might be higher or lower than its NAV. An ETF is said to be trading at a premium when it trades at a price that is higher than its net asset value.

What an ETF trades at a price lower than its NAV it is said to be trading at a discount. Authorised participants, also known as APs, help to keep the ETF’s market price in line with the value of its underlying securities. If a significant premium or discount develops, an AP can capitalise on the price difference to the ETF creation/redemption process. Creations and redemptions help to bring the supply of ETF shares more in line with demand, which in turn helps to bring the ETF's market price more in line with the value of its underlying securities.

So what are the key drivers of premiums and discounts? Their appearance is a natural outcome of the relationship between the supply and demand of ETF shares and that of the underlying securities. However, there are two additional considerations surrounding premiums and discounts. First, if the cost of buying the underlying securities is higher, the result may mean a wider range of premiums and discounts.

And secondly, if the underlying securities trade on an exchange that is open at a different time than the exchange the ETF trades on, there could be deviations between current and stale security pricing, resulting in perceived premiums or discounts. ETFs in some asset classes, for instance, fixed income, tend to have relatively large and constant premiums and discounts. A major reason for this occurrence is the pricing between the ETF and the underlying bonds.

This graphic illustrates how pricing differences can lead to an inherent premium for bond ETFs. Let's take an example. The market price of a US corporate bond ETF listed on the London Stock Exchange is calculated as the midpoint of the best bid and ask at 4:30 p.m. London time. While the underlying bonds in Vanguard ETFs are valued at their bid prices at the end of the US trading day. This pricing difference results in an inherent premium since the midpoint of the bid-ask spread on the ETF is typically going to be higher than the bid price of the underlying bonds. The level of premium or discount will also vary depending on the demand for the ETF relative to the flow in the market. As we illustrate in figure two, the greater the relative demand to buy the ETF, the higher the bid-ask quote and thus the higher the midpoint of that quote.

This could result in a larger premium. The opposite is also true. If there are more investors selling the ETF, its premium could fall and perhaps result in a discount. Bond ETF premiums and discounts can be somewhat misleading because transaction costs are more transparent within the ETF wrapper than with traditional mutual funds. In times of market stress or constrained liquidity, the bid-ask spreads of underlying securities could widen to reflect the increased costs to buy or sell the underlying securities during volatile periods. This same dynamic may also lead to larger premiums and discounts than are seen in normal market conditions. A mutual fund portfolio manager trying to buy or sell the same basket of bonds may also be paying the same bid-ask spread.

However, investors do not see these costs in real time. The costs manifest after the fact as part of the fund's NAV. To put a fine point on it, premiums and discounts in bond ETFs are largely a reflection of the externalisation of investors’ transaction costs and the real time nature of ETF pricing, when compared to a fund's NAV. There are a couple of points to consider. The spread on the underlying holdings has a clear impact on premiums and discounts since it determines the ETF’s trading range. Here are some considerations across the various asset classes. On the fixed income side, government bonds tend to be more liquid, with narrower and more consistent bid-ask spreads, causing government bond ETFs to trade with smaller premiums and discounts.

Corporate bonds tend to be less liquid, with wider and often more volatile bid-ask spreads. As a result, corporate bond ETFs tend to have larger premiums and discounts. Let's look at equities. Large cap equity shares tend to have narrower spreads and greater real time price transparency than bonds, causing large cap ETFs to trade with fewer premiums and discounts. Small cap shares tend to have wider spreads, causing small cap ETFs to have relatively larger premiums and discounts.