Premium or Discount to NAV

A premium or discount to NAV measures how far a fund's traded share price sits from the value of what the fund holds. Net asset value per share is the fund's assets minus its liabilities, divided by the shares outstanding. If the market price is above that figure the shares trade at a premium; if below, at a discount. The gap is conventionally quoted as a percentage.

The reason the name carries both words is that federal law defines them together as a single signed quantity. Rule 6c-11 under the Investment Company Act says: "Premium or discount means the positive or negative difference between the market price of an exchange-traded fund share at the time as of which the current net asset value is calculated and the exchange-traded fund's current net asset value per share, expressed as a percentage of the exchange-traded fund share's current net asset value per share." One measurement, one formula, and a sign that decides which word to use. People do say "trading at a premium to NAV" and "at a discount to NAV", and both are ordinary usage; they are the two directions of the same number rather than two different measurements.

The formula has three parts and each of them is where a calculation goes wrong. The numerator is market price minus net asset value per share, and the sign is kept rather than discarded. The base is net asset value per share, which is why a fund quoting a 0.75 percent discount is not quoting the gap divided by the price. And the timing is fixed: the market price used is the one "at the time as of which the current net asset value is calculated", ordinarily the close, so a gap that opened and shut at eleven in the morning never appears in the published figure at all.

The number is published, and knowing that is most of the practical value of understanding it. Rule 6c-11 requires an ETF, each business day, to disclose prominently on a free and publicly available website: its current net asset value per share, market price and premium or discount, each as of the end of the prior business day; a table showing the number of days its shares traded at a premium or discount during the most recently completed calendar year and the completed calendar quarters since; a line graph of the same history; and its median bid-ask spread over the last 30 calendar days, computed from the national best bid and offer at the end of each ten-second interval. A reader who wants to know whether a fund's price tracks its holdings closely does not have to estimate it. The fund publishes the record.

The tripwire is the part worth remembering, because it converts a number into an explanation. If an ETF's premium or discount is greater than 2 percent for more than seven consecutive trading days, the rule requires the fund to post a statement that it was, together with "a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount", and to keep that discussion on the website for at least a year. Persistent gaps therefore come with the fund's own account of why, in a place anyone can read without asking.

How large the gap can get depends on the structure, not on the fund's quality. An exchange-traded fund has a mechanism for closing it: authorized participants can create and redeem shares directly with the fund, which gives professional traders a reason to buy the cheaper side and sell the more expensive one until the two converge. A closed-end fund has no such mechanism, which is why its discount can be far larger and can persist for years; that analysis lives on the closed-end fund page. An interval fund has no market price at all, because it transacts with holders at net asset value rather than on an exchange, so the measurement does not arise. And an exchange-traded note has no net asset value in the first place, because it holds nothing; its price is compared with an indicative value the issuer calculates, which is a different reference and behaves differently.

A small gap is normal and is not a defect. Market prices move continuously while net asset value is struck once, holdings in overseas markets may have stopped trading hours before the fund's valuation time, and the bid-ask spread itself puts a floor under how tightly a price can track anything. The information in the number is comparative and cumulative: how large the gaps have been, how often, and whether they persist, which is exactly what the required table and line graph show.

At the end of the trading day the fund calculates its net asset value per share. It takes the market price of its shares as of that same moment, subtracts net asset value per share, and divides the result by net asset value per share. A positive answer is a premium and a negative one is a discount. The figure, and a history of it, go on the fund's public website before the next session.

A hypothetical of the arithmetic. Assume an ETF's net asset value per share is $40.00 when it is struck, and the market price at that moment is $39.70. The difference is -$0.30. Divided by the $40.00 net asset value per share, that is -0.75 percent: a discount of 0.75 percent.

Now do it the wrong way, because the wrong way is a natural mistake. Dividing the same $0.30 by the $39.70 market price gives 0.76 percent. Neither number is large and neither is dishonest, but only the first one is what the rule defines, and a difference of a hundredth of a percentage point compounds into a visible discrepancy on a fund with a wider gap. The base is always net asset value per share.

One more step, using the same fund. Suppose the discount ran at 2.4 percent for eight consecutive trading days. That is greater than 2 percent for more than seven consecutive trading days, so the rule requires the fund to post a statement that its discount exceeded 2 percent, together with a discussion of the factors it reasonably believes materially contributed, and to keep that on the website for at least a year.

Pros

• It is a defined figure rather than a market opinion, computed to a formula written into a federal rule, so two funds' numbers mean the same thing.
• An ETF relying on Rule 6c-11 has to publish it daily along with a table and a line graph of its history, so the information is free and comparable without a data subscription.
• It separates two things a price alone conflates: what the fund's holdings did, and what the market paid for access to them.
• A persistent gap comes with the fund's own explanation attached, because of the 2 percent, seven-day disclosure requirement.

Cons

• It is a snapshot taken once a day at the valuation time, so it says nothing about how far the price wandered from value during the session, which is when most people trade.
• A small figure is not automatically reassuring: the net asset value it is measured against is itself an estimate where the fund holds assets without ready market quotations.
• Buying at a discount is not a strategy on its own, because nothing forces the gap to close and, in a closed-end fund, it commonly does not.
• The measurement does not exist for every product a reader might apply it to. An interval fund has no market price and an exchange-traded note has no net asset value.