Is anyone familiar with the relationship of ETF trading at premium/discount and trading costs?
The following is a statement in Mock exam:
Note 2: ETFs can trade at either a premium or discount to the underlying, which affect trading costs negatively or positively. Exchanges disclose the indicated intraday net asset values (NAVs), which are estimates of fair value based on the creation basket. Premiums and discounts are driven by a number of factors, including timing differences and stale pricing, which can be meaningful for foreign securities.
Note 2 regarding premiums and discounts is correct.
I could not understand why ETFs trading at a premium/discount would affect trading costs negatively/positively…
For example this can be due to the demand for, or liquidity in, the ETF.
Just because an ETF holds a bunch of liquid/popular names doesn’t necessarily mean the ETF will be popular or liquid, itself. Therefore you can find wider bid/ask spreads for the ETF or you may need to sell it at a discount if you want to sell a large block share of it.
By the same token, if a popular and liquid ETF holds a few names in its holdings that are less liquid or well known/demanded, the value of these stock holdings in the ETF can benefit from narrower ETF bid/ask spreads etc., compared to if you wanted to sell the shares outside the ETF structure for example.
In other words, the market isn’t perfectly efficient. The ETF has demand, trading volume and bid/ask spreads that can be different from each of these elements in their underlying name holdings.
If you are buying an ETF trading at a slight premium (more expensive) than if you could simply replicate the ETF holdings independently in the market, you are paying more and this affects your trading costs negatively. And opposite for if the ETF is trading at a slight discount.
Cheers buddy you got this