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The Valuation of Exchange-traded Funds
The Valuation of Exchange-traded Funds
By: Wilmington Trust

One of the more complex characteristics of exchange-traded funds (ETFs) is their pricing. Unlike most mutual funds, which can be purchased or redeemed only at an end-of-day closing price, ETFs can be traded on stock exchanges all day long, much like stocks. ETFs are priced continuously during normal trading hours, so an investor can get a price at which to buy or sell a fund, anytime the market is open. In addition, ETFs have a wider variety of pricing terms than mutual funds, such as net asset value, market price, bid price, ask price, and "Intraday Indicative Value."

Oftentimes, ETFs are seen as a hybrid between stocks and mutual funds. That's because they feature pricing characteristics similar to both investments. Like mutual funds, ETFs have a net asset value (NAV). The NAVs of both mutual funds and ETFs are calculated at the end of each trading day, at market close. NAVs for both mutual funds and ETFs represent the value of the underlying securities. The NAV is calculated by taking the total assets, deducting the liabilities, and dividing by the total number of shares outstanding.

However, that's where the similarities between mutual funds and exchange-traded funds end. A mutual fund's NAV is the price that is paid to buy or sell the fund, from or to the issuer, minus any loads. No matter when an investor purchases the mutual fund during the day, the end-of-day NAV is the price that is paid. In contrast, as soon as an ETF begins trading, its market price and NAV may diverge. Therefore, the market price, or the price an investor pays to buy the ETF or gets when the ETF is sold, may not necessarily equal the ETF's NAV. In addition to changes in the value of underlying securities affecting NAV, ETF prices are also determined by market supply and demand for the ETF, as well as the opportunity for arbitrage (explained below). The bottom line is that if two investors purchase the same ETF on the same day, they may end up paying different prices due to market fluctuations.

Like stocks, ETFs have a bid price, the highest price any buyer is willing to pay for the ETF, and an ask price, the lowest price any seller is willing to accept for an ETF. The difference between the current bid and ask prices is known as the bid/ask spread, or simply, "the spread." Depending on the liquidity of the underlying securities, market volatility, and other factors, investors may purchase shares at a premium or discount to their NAV. When demand for ETF shares exceeds supply, the market price at which an index ETF trades may be higher than its underlying net asset value, and typically the price is at a premium to NAV. If the NAV of a fund is $20, and the fund is selling for $20.20 on an exchange, the fund is said to be at a 1% premium to NAV. When there are more fund sellers than buyers, the market price may be at a discount to NAV; that is, its market price is lower than its NAV. For example, if the NAV of a fund is $20, and the fund is selling for $19.80 on an exchange, the fund is said to be at a 1% discount to NAV. Market forces, such as the fact that investors want to make reasonably-priced transactions, usually help keep the bid/ask close to the NAV.

As an ETF trades throughout the day, investors still need to know an approximation of the ETF's NAV. That's where the Intraday Indicative Value (IIV)—also known as Indicative Value (IV)—comes in. This value is calculated by the exchange using a Portfolio Composition File that is provided by the ETF advisor. The exchange publishes the IIV every 15 seconds throughout the trading day. It approximates the ETF's NAV, and because it's updated so frequently, investors always know the approximate value of the ETF. The indicative value does not reflect a value at which the ETF share can be purchased or sold in the market, or created or redeemed from the issuer; that would be reflected in the bid/ask and the NAV, respectively. Investors can easily track this activity, because each ETF IIV has its own ticker symbol.

When and how investors use the various prices when managing ETFs depends on what they need to know. For instance, market price tells an investor the last trading price, and is the price that appears online or in newspapers each day. The NAV tells the investor the value of the underlying securities in an ETF, while the IIV, calculated every 15 seconds, enables an investor to have a real-time estimate of the NAV. The IIV can serve as a guide, when placing market orders or limit orders to trade.

ETFs that track the performance of an international equity index have a unique aspect. That's because most of the underlying global equity markets are closed when the ETF is trading here in the United States. However, information and news flow regarding global stocks continues throughout the day, and is constantly being processed by investors, corporations, and financial institutions. This process is known as "price discovery," and the ETF reflects actionable market prices, while the underlying securities cannot be priced. In times of increased volatility and uncertainty, the market price of an international equity index ETF may deviate widely from the net asset value of the ETF, reflecting investor concern.

For investors willing to take the time to understand exchange-traded funds—and for whom the risk is appropriate—ETFs offer a broad range of opportunities when seeking specific sector exposure.

Editor's note: Please refer to our related article, "An Introduction to Exchange-traded Funds."

Updated: January 1, 2013

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.

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