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ETF Returns: Market vs. NAV Returns

Dec 21, 2012 Marc Odo

At Zephyr Associates we occasionally get questions about the different ways to calculate ETF returns, specifically NAV returns versus market returns. Both methodologies are correct, but sometimes yield different results.

Open ended mutual funds are priced once a day, and the issuer has an open offer to buy or sell any number of shares of the funds at NAV. If you think of it as an algebra equation, the NAV is set in stone at the end of the day. In order to keep the supply and demand for the funds in balance and the price fixed, the issuer can eliminate or create as many shares of the mutual fund as he needs to keep the overall equation in balance, and to keep any discrepancies or arbitrage opportunities from opening up due to mismatches in supply & demand or pricing. So far, so good.

ETFs, however, are different. ETFs are really a hybrid vehicle, a combination of mutual funds and individual stocks. Yes, like open ended mutual funds they are a basket of securities whose value SHOULD equal NAV. However, they trade like stocks in the sense that people put in buys and sells for shares and they price constantly throughout the day.  If there are supply and demand mismatches a gap can open up between what the value SHOULD be (the NAV price) and what the investor might ACTUALLY be able to buy at (the market return). So, in this sense, the discount or premium that opens up actually makes the ETF more like a third type of vehicle, the closed-end fund.

Now, in normal markets this isn’t too much of a problem, because arbitrageurs can step in and gain a riskless profit by narrowing that gap, but as we all know the last several years haven’t been exactly normal markets. The illiquidity has caused some of these premiums and discounts to open up to the point where the performance numbers are indeed different.

Zephyr offers both market and NAV returns in the Morningstar ETF database.

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