An exchange-traded fund's market price is the price at which shares in the ETF can be bought or sold on the exchanges during trading hours, while the net asset value (NAV) represents the value of each share’s portion of the fund’s underlying assets and cash at the end of the trading day. ETFs calculate the NAV at 4 p.m. EST, after the markets close.
The NAV is determined by adding up the value of all assets in the fund, including assets and cash, subtracting any liabilities, and then dividing that value by the number of outstanding shares in the ETF. The NAV is used to compare the performance of different funds, as well as for accounting purposes. The ETF also releases its current daily holdings, amount of cash, outstanding shares and accrued dividends, if applicable. For investors, ETFs have the advantage of being more transparent. Mutual funds and closed-end funds do not have to disclose their daily holdings. In fact, mutual funds usually disclose their holdings only quarterly.
There may be differences between the market closing price for the ETF and the NAV. Any deviations should be relatively minor, however. This is due to the redemption mechanism used by ETFs. Redemption mechanisms keep an ETF's market value and NAV value reasonably close. The ETF uses an authorized participant (AP) to form creation units. For an ETF tracking the S&P 500, an AP would form a creation unit of shares in all the S&P 500 companies in a weighting equal to that of the underlying index. The AP would then transfer the creation unit to the ETF provider on an equal NAV value basis. In return, the AP would receive a similarly valued block of shares in the ETF. The AP can then sell those shares in the open market. The creation units are usually anywhere from 25,000 to 600,000 shares of the ETF.
The redemption mechanism helps keep the market and NAV values in line. The AP can easily arbitrage any discrepancies between the market value and the NAV during the course of the trading day. The ETF shares' market value naturally fluctuates during the trading day. If the market value gets too high compared to the NAV, the AP can step in and buy the ETF's underlying constituent components while simultaneously selling ETF shares.
In the alternative, the AP can buy the ETF shares and sell the underlying components if the ETF market value gets too far below the NAV. These opportunities can provide a quick and relatively risk-free profit for the AP while also keeping the values close together. There may be multiple APs for an ETF, ensuring that more than one party can step in to arbitrage away any price discrepancies.