How Are ETF Prices Determined? Understanding NAV, iNAV, and the Tracking Error

Understanding at a Glance

An ETF (Exchange-Traded Fund) is a fund that can be bought and sold in real time on a stock exchange, just like stocks. At first glance, it may seem as though the price is determined by buy and sell orders, much like a stock price, but there is one important criterion that distinguishes ETFs from regular stocks: the value of the assets the ETF actually holds.

To properly understand ETF prices, you need to distinguish between the following three concepts:

1. NAV: The benchmark price that shows the actual net asset value of one share of an ETF
2. iNAV: The real-time estimated net asset value of an ETF during trading hours
3. Market Price: The price at which investors actually buy and sell on the exchange

These three prices are interconnected but are not always exactly the same.

Key Terms for Understanding ETF Prices

1. ETFs Have a Benchmark Price Called NAV

The price of a typical stock is fundamentally determined by buy and sell orders placed by investors in the market. While factors such as corporate earnings, interest rates, and industry outlook certainly influence the price, the trading price itself is determined by market supply and demand.

Although ETFs are also traded in real time on exchanges, they have a benchmark price that differs from that of individual stocks. Since an ETF is a fund that holds various stocks, bonds, commodity-related products, and cash-equivalent assets, it is possible to calculate the value of its holdings. The value used for this calculation is NAV (Net Asset Value).

Basic Formula for NAV

NAV is generally calculated as follows:

Total NAV of the ETF = Value of assets held by the ETF – Liabilities
NAV per ETF share = Total NAV of the ETF ÷ Number of ETF shares issued

For example, if an ETF has total assets worth 100 billion won, no liabilities, and 10 million shares outstanding, the calculation would be as follows:

In this case, one share of the ETF can theoretically be considered to have a net asset value of 10,000 won.

2. NAV is typically calculated once a day

Although NAV is the official benchmark price for an ETF, it is generally calculated once a day after the market closes, based on the prices of the assets held. The problem is that ETFs continue to trade throughout the trading day.

For example, an investor looking to buy an ETF at 10:00 a.m. would find it difficult to make a purchase decision based solely on the NAV calculated using the previous day’s closing price. This is because the prices of the stocks and bonds held by the ETF continue to fluctuate throughout the trading day.

Therefore, iNAV (indicative NAV) is used alongside NAV during trading hours.

3. iNAV is a real-time, intraday estimate of value

iNAV is an intraday indicator that estimates the current value of an ETF. It is calculated repeatedly throughout the trading day to reflect changes in the prices of the ETF’s underlying assets.

Investors can use iNAV to determine the following:

• Whether the ETF is currently trading close to its actual value
• Whether the ETF’s market price is higher than the value of its underlying assets
• Whether the ETF’s market price is lower than the value of its underlying assets
• Whether intraday buy and sell prices are excessively unfavorable

However, iNAV is still an “estimate.” In particular, for ETFs holding overseas assets, assets from markets with different trading hours, or illiquid assets, there may be a discrepancy between iNAV and the actual perceived value.

4. An ETF’s market price is determined by buy and sell orders

An ETF’s actual trading price is determined on the exchange’s order book, just like a stock. In other words, when buy orders and sell orders placed by investors match, a trade is executed, and that execution price becomes the market price.

Therefore, an ETF’s market price does not necessarily match its NAV or iNAV.

For example, even if an ETF’s intraday iNAV is 10,000 won, it may trade in the market as follows:

Market prices are influenced by the following factors:

• Buy and sell demand for the ETF itself
• Volatility in the price of the underlying assets
• ETF trading volume and bid-ask spread
• Liquidity of the holdings
• Time difference between trading hours in overseas and domestic markets
• Exchange rate fluctuations
• Conditions under which market makers (LPs) quote prices during market volatility

5. The tracking error indicates how much the ETF price differs from its reference value

The tracking error is a ratio that indicates how much the ETF’s market price differs from its NAV or iNAV.

Generally, it can be understood as follows:

Price-to-Net-Asset-Value Ratio = (Market Price - Net Asset Value) ÷ Net Asset Value × 100

Here, the net asset value can be either NAV or iNAV, depending on the situation. During trading hours, iNAV is often used as a reference to determine whether the market price is overvalued or undervalued.

Examples of the Spread Rate

If the tracking error is large, investors may face the following disadvantages:

• They may buy the ETF at a price higher than its actual value
• They may sell the ETF at a price lower than its actual value
• Losses may occur solely due to price differences during short-term trading

Therefore, when trading ETFs, it is advisable to check not only the percentage increase from the previous day but also whether the current market price has deviated significantly from the iNAV.

6. LPs Help Prevent Excessive Deviations in ETF Prices

The ETF market typically involves LPs (Liquidity Providers), also known as market makers. LPs provide liquidity by quoting bid and ask prices for ETFs, enabling investors to trade.

The key roles of LPs are as follows:

• Provide bid and ask prices so that investors can easily buy and sell ETFs
• Help ensure that the ETF’s market price does not deviate significantly from the value of its underlying assets
• Helping to prevent the spread—the difference between the bid and ask prices—from widening excessively

For example, if an ETF’s iNAV is 10,000 won but the market price rises to 10,200 won, an LP can post an ask price to temper the price increase. Conversely, if the ETF’s market price drops to 9,800 won, the LP can submit a bid to help limit the extent of the price decline.

However, the presence of an LP does not guarantee that the ETF price will always exactly match its iNAV. In situations such as sudden market volatility, a lack of liquidity in the underlying assets, overseas market closures, sharp fluctuations in exchange rates, or low trading volume, the tracking error may widen.

7. ETF Prices Are Also Adjusted Through “Arbitrage Mechanisms”

ETFs generally have mechanisms in place to reduce the difference between the market price and the net asset value. Prime examples of this are ETF creation and redemption, along with arbitrage mechanisms.

Conceptually, it works as follows:

• If the ETF price is higher than the value of its underlying assets, market participants have an incentive to reduce the price difference by creating new shares or selling existing shares.
• If the ETF price is lower than the value of the underlying assets, market participants have an incentive to buy the ETF or utilize the redemption mechanism to narrow the price gap.

Because of this structure, ETF market prices tend to stay closer to their net asset value than those of typical closed-end funds. However, this mechanism does not always function perfectly, depending on market conditions.

8. Key Metrics to Check When Reviewing ETF Prices

Before buying or selling an ETF, it is advisable to review the following metrics.

9. Are Premiums and Discounts Always Investment Opportunities?

Just because an ETF is trading below its iNAV doesn’t always mean it’s a good buying opportunity. Conversely, just because it’s trading above its iNAV doesn’t necessarily mean you should avoid it.

You should exercise caution when interpreting the tracking error in the following situations.

ETFs Tracking Overseas Assets

Overseas markets for the underlying assets may be closed during domestic trading hours. In such cases, the ETF’s market price may reflect not just the latest price of the underlying asset, but also investors’ expectations regarding the next move in the overseas market and exchange rate expectations.

Bond ETFs

Real-time price discovery for bonds is often less active than for stocks. For some bond ETFs, a discrepancy may arise between the valuation of the bonds held and the actual tradable price.

Periods of Sharp Market Declines or Rallies

When the market fluctuates sharply, the prices of an ETF’s underlying assets, exchange rates, bid-ask spreads, and investor orders all fluctuate simultaneously. In such cases, the tracking error may temporarily widen.

ETFs with Low Trading Volume

For ETFs with low trading volume and thin order books, even small orders can cause significant price movements. In such cases, limit orders may be more appropriate than market orders.

10. Key Points for ETF Investors to Remember in Real-World Trading

It is difficult to assess an ETF’s price based solely on the current price displayed on the screen. Especially when engaging in short-term trading or trading large amounts, you should also check the NAV, iNAV, tracking error, and bid-ask spread.

Here is a practical checklist:

• Is the current price excessively higher or lower than the iNAV?
• Has the tracking error widened significantly compared to usual?
• Is the difference between the bid and ask prices too large?
• Is trading volume sufficient?
• If it’s an ETF tracking overseas assets, have you considered exchange rates and the time difference with overseas markets?
• Is this a situation where a limit order would be more appropriate than a market order?
• Have you prioritized the ETF’s underlying index and investment objective over short-term price fluctuations?

Conclusion

An ETF’s price must be understood on two levels. One is the NAV and iNAV—the value of the assets the ETF actually holds—and the other is the market price formed by investor orders on the exchange.

While an ETF’s market price generally tracks the value of its underlying assets, it can trade at a premium or a discount depending on supply and demand and market conditions. The spread rate is an indicator of this difference, and the structures involving market makers (LPs) and arbitrage help prevent this difference from becoming excessive.

Therefore, when trading ETFs, it is important not to focus solely on the current price but to also check iNAV, the tracking error, bid-ask spreads, trading volume, and the status of the underlying assets.