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Exchange-Traded Funds (ETFs) have been broadly embraced as flexible and cost-effective investment vehicles, which are widely regarded for their transparency and efficiency. As the ETF market continues to grow rapidly, understanding nuance is essential. It’s important to examine the total cost of ETF ownership by looking beyond fees and bid/ask spreads to consider premiums and discounts when trading an ETF.
Investors should consider how the way ETFs are created and redeemed can significantly impact investor outcomes, especially when it comes to premiums and discounts. Specifically, investors should be aware of how in-kind custom basket1 processes may drive down costs and improve the ETF trading experience.
A robust in-kind custom basket process enables market makers to deliver or receive securities—rather than cash—when creating or redeeming ETF shares."
Not all ETF creation and redemption processes are equal. Many ETFs rely solely on cash transactions for investors entering or exiting the fund. This may create extra costs, as most ETFs charge a standard additional charge (SAC) fee whenever they create or redeem shares. These costs often get passed on to investors in the form of wider premiums and discounts relative to the ETF’s net asset value (NAV).
A robust in-kind custom basket process enables market makers to deliver or receive securities—rather than cash—when creating or redeeming ETF shares. This flexibility is tax efficient and allows market makers to use the securities they already hold, helping to reduce transaction costs and eliminating the need to pay cash fees. This can encourage market makers to buy and sell ETF shares within tighter price ranges, allowing investors to trade closer to the true NAV and avoid excessive premiums or discounts.
What are premiums and discounts?
When an ETF trades at a premium, its market price is higher than the NAV of its underlying assets, which means investors are paying more than the value of the components. High demand, optimistic investor sentiment or situations where the market price can move independently of the stale NAV due to factors like time zone differences may result in a premium.
When an ETF trades below its NAV, it is trading at a discount. Sellers receive less than the fair value for their shares when the market price is lower than the value of the underlying assets. A lack of demand relative to supply, market volatility or illiquidity, especially in funds with international securities or less transparent assets, may cause a discount.
Both premiums and discounts can erode returns if not managed effectively. The ability to create and redeem in-kind—especially with custom baskets tailored to market conditions—helps keep ETF prices closely aligned with their NAV, benefiting investors at both entry and exit.
How do in-kind processes influence market makers?
When ETF issuers offer a sophisticated in-kind custom basket process, market makers are empowered to facilitate trades without incurring the extra costs associated with cash transactions. Rather than factoring in a cash fee, they can transact using their existing inventory. This results in narrower bid-ask spreads, reduced premiums and discounts, and a more efficient trading environment for clients.
Conversely, if an ETF behaves more like a mutual fund and requires cash for all creations and redemptions, the benefits of the ETF structure are diminished. Market makers must account for the cash fee, often widening spreads and increasing the cost to investors. This is especially pronounced during periods of market stress or for less liquid ETFs.
What is total cost of ownership (TCO)?
When considering the total cost of ownership (TCO) of an ETF, investors should look beyond management fees, trading volume and bid/ask spreads. The creation and redemption process has a direct impact on the premiums and discounts paid, and an in-kind custom basket approach may reduce costs.
Investors should always review the ETF’s historical premiums and discounts. It is important to determine whether the fund trades with large premiums when there is an inflow cycle and large discounts when there are outflows. It is also vital to monitor bid-ask spreads, as efficient in-kind processing leads to tighter spreads and lower transaction costs.
Bottom Line: The total cost of ETF ownership is shaped by much more than management fees. Volumes and bid/ask spreads are key metrics to consider, but even if an ETF trades a penny wide, investors should be mindful about the premiums and discounts they may experience. By prioritizing an in-kind custom basket process, ETF issuers help maintain tight pricing, lower premiums and discounts, ultimately leading to potentially better client outcomes.
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