Here’s a Case Study in How Investors Can Overpay for ETFs

It is possible to overpay for an exchange-traded fund — ETF. Two recent examples of excessive valuations involve Egyptian and Japanese ETFs.

As of Wednesday’s close, Market Vectors’ Egypt Index ETF (NYSE:EGPT) was trading at a 2.3% premium to its net asset value. This is down from Tuesday’s premium of 5.7%. Net asset value — NAV — is the worth of the basket of assets the fund is designed to track. In the case of EGPT, it would be basket of securities with exposure to Egypt.

Last week, IndexUniverse.com, a news source on ETFs, noted that Japanese ETFs closed at premiums of 7% or more to their net asset values. This included iShares MSCI Japan (NYSE:EWJ), which has an average daily trading volume of 45 million shares. In other words, this is very actively traded fund.

Since investing is messy, there are a few caveats to be aware of. The first is the difference in time zones. The Egyptian and Japanese markets are open during different hours than the U.S. markets, resulting in some fluctuations in the funds’ pricing relative to NAV. (Both funds hold securities traded on foreign exchanges.) Secondly, changes in currency rates also play a role. These two factors may partially explain why EWJ was priced at an eight-cent per share premium to its NAV as of Wednesday evening.

It should also be noted that Egypt’s stock market has had a difficult time reopening. On Wednesday, the bourse opened for the first time since January 27. Stocks quickly plunged, prompting a halt in trading. (Egyptian stocks ended the day down 8.95%.) Today, the market fell 5.5% before circuit breakers kicked in and suspended trading for 30 minutes. (A circuit breaker is a rule designed to stop trading when prices move by a certain magnitude over a specific period of time.)

Egypt is a special situation because of the recent government ouster. The drop in the Egyptian markets also shows the risks of investing in a country-specific emerging market ETF (NYSE:EEM).

What I want to point out to you this week, however, is the importance of paying attention to an ETF’s net asset value before purchasing it. Though most ETFs do trade very closely to their NAVs, discrepancies can and do happen. A minor difference (e.g., a two-cent difference on an ETF that trades at $50 per share) is not very significant; a measurable premium is. In such cases, you are simply overpaying for no reason.

(This same logic also applies to closed-end funds, which are more likely to trade at notable premiums or discounts to their net asset values.)

You can find the current net asset value on a fund family’s website. For example, information on EWJ is available at www.ishares.com. You should also spend time reviewing the fund’s holdings and its prospectus.

Charles Rotblut, CFA, is a Vice President with the American Association of Individual Investors. His new book is Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio.