ETF Premiums, Discounts and Tracking Difference

An ETF has two prices at any moment: the price it trades at on the exchange, and its net asset value (NAV) — the value of the basket of securities it actually holds, divided by shares outstanding. In principle these should be identical, since creation and redemption lets authorized participants swap ETF shares for the underlying basket (or vice versa) whenever a gap opens, arbitraging it away. In practice a small gap almost always exists, and it comes in two different flavors worth telling apart.

Premium/discount is the intraday gap between market price and NAV, quoted as a percentage:

$$\text{Premium} = \frac{\text{Market price} - \text{NAV}}{\text{NAV}}$$

This is usually tiny (a few basis points) for a liquid US equity ETF, because the arbitrage is fast and cheap. It widens for ETFs holding illiquid or foreign-market securities — an ETF of Japanese stocks trading during US hours has a stale NAV (Tokyo is closed), so its US market price, reflecting live sentiment, can drift meaningfully from the last-known NAV until Tokyo reopens.

Tracking difference is a separate, slower-moving number: the gap between the ETF's return and its benchmark index's return over a period, mainly driven by the expense ratio, but also by sampling error, securities lending income (which can partly offset costs), and cash drag.

$$\text{Tracking difference}_{1\text{yr}} = R_{\text{ETF}} - R_{\text{index}}$$

A worked example

An ETF's NAV is calculated at $100.00 at the close, but the fund trades at $100.15 on the exchange — a premium of $0.15/100.00 = 0.15\%$, well within normal bid-ask friction for a liquid fund. Over the following year, the underlying index returns 10.00% while the ETF, after a 0.20% expense ratio and minor sampling drag, returns 9.75% — a tracking difference of $-0.25\%$, slightly worse than the expense ratio alone would predict.