Why does a fund's price differ from what it is worth?
A fund's units trade at a price; the fund's holdings have a value. The two are pulled together by a mechanism and pushed apart by circumstance, and the gap has a name: a unit trading above NAV is at a premium, below it at a discount.
The closed-end fund shows the gap at full size
Because a closed-end fund has no daily creation or redemption, nothing forces its price toward its NAV. Discounts of 10% or more persist for years on some funds, and premiums appear where a fund holds something investors cannot easily buy any other way. The discount is not an error; it is the market's verdict on the manager, the fees and the liquidity of what is inside, all rolled into one number that the NAV does not carry.
That is the pure case, and it is worth knowing because an ETF trades the same way — on an exchange, between investors — with one extra mechanism bolted on that makes it open-ended.
The ETF keeps the gap small, most of the time
An ETF's market price hovers within a few hundredths of a percent of its NAV on an ordinary day, for a large fund holding liquid shares. It does that because a group of specialist firms can create new units by handing the fund the underlying holdings, and redeem units for those holdings, at NAV. If the price drifts above NAV they create and sell; below, they buy and redeem. The next lesson is the mechanism in detail. Here the point is the consequence: the arbitrage works exactly as well as the underlying holdings can be traded.
When the gap opens
Three circumstances, all worth recognising on sight.
The underlying market is closed while the ETF trades. A US-listed fund of Japanese shares trades all of New York's day while Tokyo is shut. Its price then reflects what investors think Tokyo will do at the open — a forecast — and the stale NAV is the number that is wrong, not the price.
The underlying is hard to trade. In the second week of March 2020, corporate bond ETFs traded several percent below their NAVs; the largest investment-grade bond fund closed about 5% under on 12 March. The bonds themselves had barely printed a trade all day, so the NAV was built from stale quotes while the ETF price was the only live estimate of what the bonds were worth. The gap was the ETF telling the truth faster than the NAV could.
The fund holds something with its own premium. A commodity fund whose futures market has gone into a squeeze, or a fund that has suspended creations, can trade far above what it holds because nobody can make more units to sell.
Reading the gap
A premium or discount is information, and it reads differently by wrapper. On a closed-end fund it is a durable opinion. On an ETF it is a stress gauge: near zero in calm markets, opening when the holdings stop trading, and closing again when they resume. A learner who knows that reads a 3% discount in a crisis as "the bond market is frozen", which is useful, rather than as "the fund is broken", which is wrong.
In the data
A fund's price is everywhere; its NAV per unit is not. What a fund's data record gives for the value side is the size of the whole pool. The high-yield bond fund from the March 2020 story:
The first line is the whole pool, the second the price of one unit. Setting one against the other needs the number of units in issue on the same day, and that, with the per-unit NAV itself, comes from the fund's own daily posting on its website. The March 2020 discounts in this lesson were read from those postings.
Try it now
- Take a fund of foreign shares, listed in New York, and look at one week of it at daily bars:
- Every one of those daily moves happened while most of the fund's holdings were not trading. Write down what the price is doing on such a day: it is estimating, and the NAV will catch up at the next foreign open.
- Then a fund of high-yield bonds over the year that included the 2020 freeze, if your range reaches it — otherwise the most stressed stretch you can find:
Measure the sharpest fall. Part of that move was the bonds falling and part was the discount opening; the chart cannot tell you which, and knowing that it cannot is the lesson.