ETF Premiums: No Worry—Until They Bite

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Headlines today focused on big outflows from the iShares iBoxx High Yield Bond ETF (NYSEArca:HYG). But the real story was the object lesson on how terrible ETF trading can cost you big, big money.

It's axiomatic in ETFs that everyone wants a fair deal. It's axiomatic in life really. Nobody ever wants to pay too much when they're buying something, or get too little when they're selling.

With most ETFs, this is never an issue. A fund like the SPDR S&P 500 ETF (NYSEArca:SPY) trades within a penny of the fair value of its underlying stocks-day in; day out; all day; every day.

The reason this is so is because of the creation/redemption process. If investors buy a lot of SPY, driving the price up over its fair value, authorized participants swoop in and arbitrage-out the price difference, creating new shares of SPY to sell, while buying up the underlying stocks of the S&P 500 Index. This helps depress SPY's price while simultaneously supporting the prices of the underlying stocks.

And because it works so well so much of the time, I generally tell folks not to stress too much about premiums and discounts. But there are two cases where you can learn a lot-and potentially save some money-by paying attention.

First, let's take the case of international funds. Most international ETFs will show a measurable premium or discount on any given day because they trade while their underlying securities are done changing hands for the day.

That means the net asset value ( NAV ) is "stale" at 4 p.m., while the market price is "live." Such is the case with iShares' popular EAFE ETF, the iShares MSCI EAFE Index Fund (NYSEArca:EFA).

Two things are going on in this ETF that make it vastly different than its kissing cousin, EFA.

The first is that Vanguard "fair-values" its NAV at the end of the day. That means that instead of relying on the closing price of Toyota Motor Corp in Japan, Vanguard revalues the stock based on how proxies-futures and American depositary receipts-have traded during the U.S. trading session. This serves to remove most of the noise from the chart. Gone is the random mean reversion.

What then explains the slight, but persistent, premium here? The blue line again represents shares outstanding. For most of this three-year period, VEA has been steadily gaining assets. In periods of slight decline or flat growth like in the fall of 2011, the premium disappears or swings to discounts.

But in general, this is the story of slow, steady buying pressure keeping the price of the ETF in the open market just a bit above fair value. And, as long as this kind of premium persists, the changes are reasonable, so you shouldn't care too much. Someone in this period most likely bought when the fund was at a premium of 20 basis points or so, and would probably have sold at a similar level.

But "probably" can really bite you in the you-know-what, as investors in the iShares iBoxx High Yield Bond Fund ETF might have discovered in the last few days.

Don't forget to check's ETF Data section.

Copyright ® 2012 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: EFA , HYG , NAV , SPY , VEA

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