ETFs, or Exchange-Traded Funds, are a type of security that trades on a market, and the prices change daily. As prices change, you might try to decide when you should buy or sell an ETF, but what if it is over or underpriced? How do you know if an ETF is overpriced?
An ETF is overpriced if its net asset value, or NAV, is lower than its market price. The market price can change throughout the day, and the NAV of an ETF changes daily. Whether or not the ETF is overpriced can change multiple times per day as the market changes, and it can also be underpriced.
This article will explain what ETFs are, what net asset value is, and how both are calculated. You’ll learn how to compare the NAV and the market price of an ETF to determine whether or not it is overpriced. Finally, there are some resources you can use to learn more about NAVs and ETFs, so let’s get started.
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Table of Contents
ETFs and Net Asset Value
ETFs are securities that track a group of other securities or indexes, and within an ETF can be stocks, bonds, or other assets. The ETF tracks the value and performance of the securities within it.
Investors buy and sell ETFs as part of their investment portfolio. They trade on a market just like stocks, and the prices change when the market is open throughout the day.
As prices change, investors trade the securities.
ETFs can be under or overpriced depending on the securities within them, how the market is trending, and its value. When you analyze the price of an ETF, you need to know its net asset value or NAV.
According to Investopedia, the net asset value (NAV) represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities. The NAV represents one share of an ETF, which is calculated every day when the market closes, which is at 4 PM Eastern Time in the U.S.
For example, let’s calculate the NAV of an ETF with a total asset value of $10 million. If the liabilities are $1 million, you will subtract the liabilities from the assets to get a NAV of $9 million.
Taking the example a step further, you can calculate the NAV per share of the ETF. Let’s say that 1.8 million shares are outstanding. Take the total NAV of 9 million, and divide it by the 1.8 million shares.
The NAV per share is $5.
Comparing ETF NAV and ETF Prices
To determine whether or not an ETF is overpriced, you need to compare the price to the NAV, which is either the market price or the price that the ETF is currently trading at. Similar to NAV, the market price changes daily, if not more.
The market price of an ETF will fluctuate throughout the day until the market closes.
Since the market price fluctuates and the NAV changes daily, the two values usually differ. This difference will help you determine if an ETF is overpriced.
An ETF is considered to be overpriced when the NAV is lower than the market price. In this situation, you are paying more than the value of the investment, which is also called buying at a premium.
On the other hand, if the NAV is higher than the market price, the ETF is said to be trading at a discount since the value of the ETF is more than what you will pay for it. This situation is where an ETF would be considered underpriced.
However, if you are selling, you want the ETF’s NAV to be lower than the market price or trading at a premium. You want to avoid selling when the ETF is trading at a discount or when the NAV is higher than the market price.
The difference between NAV and the market’s closing price is usually small, thanks to something called the redemption mechanism, which uses authorized participants, or APs, to keep the NAV and the market price close.
When there is a large difference between the two, APs will profit from arbitraging ETF prices until they are closer to the NAV.
Why Net Asset Value Matters?
NAV matters because it helps you determine whether or not an ETF is overpriced, even if the difference between NAV and ETF is small.
The NAV on two different dates can also help you determine how the value of an ETF has changed over a certain period. The difference can give a good basic analysis of the change of an ETF over time, but some factors can affect the change.
For example, if an ETF has higher fees on the second of two dates, the NAV will be different. But, the difference does not mean that the value of the securities within the ETF changed. It just means that there is a higher amount of liabilities on the second date, so the NAV is lower.
However, you can still compare the NAVs from two dates to the market prices from those same dates to determine if the ETFs have gone from overpriced to underpriced or vice versa. For example, if the NAV was higher than the market price on April 1, but on April 30, the market price was higher than the NAV, the ETF went from underpriced to overpriced.
The situation is similar if the NAV is lower than the market price on one date, then changes to where the market price is higher than the NAV.
The ETF will go from overpriced to underpriced.
Learn More About ETFs and NAV
Knowing how ETFs work and how NAV can help you find securities to invest in is important for any investor, beginner or not. The resources in this section will give you a foundation for understanding ETFs and NAV, and they are all found on Amazon.com.
- Investing in ETFs For Dummies: It has all the basics you need to know about ETFs. You will learn how the market works, how to choose the right ETFs to invest in, and how they can be a great addition to your investment portfolio.
- Index Funds and ETFs: What they are and how to make them work for you: This book discusses how ETFs are better than other benefits and how you can avoid common mistakes that investors make when investing in ETFs. There is also information on index funds and how they are similar and different from ETFs.
- The Net Current Asset Value Approach To Stock Investing: This book will teach you how to invest using a method that focuses on NAV. You can use this pricing method alone to analyze investments or use it with other indicators to find the best investments.
If you want to learn more about net asset value, start with this video from Invesco, which explains how the NAV of an ETF is calculated:
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
An ETF is overpriced when the market price is higher than the NAV.
This difference comes down to the assets and liabilities of the securities within an ETF, and the market price is the current trading price which can change multiple times per day.
The NAV and the market price will often not have a huge difference because of redemption mechanisms that keep the difference small, but the difference will still indicate whether or not the ETF is overpriced.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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