If the price of a fund is lower than its NAV, the ETF is trading at a "discount" -- you're buying the ETF for less than the value of the fund's holdings. If the price of the fund is higher than its NAV, the ETF is trading at a "premium" -- the amount you're paying is a little more than what the underlying holdings are actually worth.
To find out if an ETF is trading at a premium or discount, go to Google Finance and type in the ETF ticker, followed by .IV. For example, the SPDR S&P 500 ETF ticker is SPY, but the underlying trading value symbol is SPY.IV.
Trading firms may buy or sell the underlying basket, take the other side of the trade through the ETF itself and "arb out" the price difference, which keeps trades close to the underlying values.
ETFs generally reflect their true underlying value, which makes them transparent and a more attractive investment for investors who aren't content with closed-ended funds' inherent discount/premium issues.
Concerns About Liquidity?
Advisors concerned about liquidity in a low-volume ETF are not necessarily trapped; there are options.
Advisors trying to execute orders of 5,000 shares or more should contact a trading desk to help facilitate trades. The trading desk should also be familiar with the pricing nuances of ETFs.
Advisors should opt to avoid the use of market orders, regardless of the ETF. Market orders have the potential to diminish a portfolio's performance due to lost basis points in trades. Limit orders provide a better alternative and help maintain control on how and when a trade is placed. However, there is a risk that a limit order will not go through.
One option is the use of an alternative liquidity provider. The provider facilitates the process of trading ETFs by generating a market for thinly-traded funds, making it possible for people to invest in ETFs without worrying about potential liquidity problems.
These liquidity providers have been around since the advent of ETFs, but now have expanded their services beyond institutional clients to assist investment advisors. Their services can offer better access to price discovery and execution for those in need of it.
To ensure smooth block trades in low-volume funds and optimal executions, advisors should be familiar with their custody ETF trading platform and broker-dealer trading desks, as well as have relations with liquidity providers. Liquidity providers and dedicated ETF trading desks will help advisors lock in target-basis points with more efficient executions, and perhaps, even better portfolio performances through optimized trading techniques.