The Money Maze
Listen

The Money Maze TMM Nº 019

Why ETFs and REITs Trade Below NAV: Tracking Error Explained

7 min

Loads the Spotify player. Spotify sets its own cookies.

Why ETFs and REITs trade at a discount or premium to NAV, what tracking error and tracking difference mean, and why your rand MSCI World ETF lags.

Show notes

Ever stared at your app wondering why your ETF or REIT is misbehaving? The price looks lekker one moment and wobbles the next, and your “index” fund didn’t quite match the index. The culprits: discounts, premiums and that sneaky villain, tracking error.

By The Money Maze | Listen to the episode: Spotify

Two separate questions get mixed up here. First: why does a fund’s market price differ from the value of what it owns? Second: why does an index fund’s return differ from the index? Let’s take them one at a time.

Quick NAV recap

NAV, or net asset value, is what a fund or property company owns, minus what it owes, divided by the number of units or shares. Think of it as the “real” value of one unit.

But NAV says R20 doesn’t mean you’ll trade at R20. On the JSE, you buy at the market price, which is set by buyers and sellers. That’s where the drama starts.

Premiums and discounts to NAV

If a fund has a NAV of R20 and trades at R17, it’s at a 15% discount. At R22, it’s at a 10% premium.

Sounds like a Black Friday special. Sometimes it is. Sometimes it’s a second-hand Hilux with no engine.

Why REITs trade below NAV

Real estate investment trusts (REITs) often trade at discounts to their reported NAV, sometimes big ones. Reasons include:

  • Valuation doubts: NAV is based on property valuations, which are estimates and lag the market. If investors think the valuations are too optimistic, they mark the share price down.
  • Future expectations: NAV looks backwards. If investors expect rising vacancies, falling rents or higher interest rates, prices fall below NAV before valuations catch up.
  • Debt: highly geared REITs get punished harder when rates rise.
  • Sentiment and liquidity: out-of-favour sectors and thinly traded shares can sit at discounts for years.

Here’s how it plays out. A REIT reports NAV of R20 a share. Investors worry that two big tenants are leaving and that the property valuer is too optimistic, so the share trades at R14, a 30% discount. If the REIT then sells a property at close to book value, like Vukile did with some Spanish retail parks, the market gets evidence that the NAV is real, and the discount can narrow. If it sells at a big loss, the market was right to be sceptical.

A discount might be an opportunity, or a giant red flag. A lot like dating.

Why ETFs usually trade close to NAV

ETFs are designed to trade close to NAV. Market makers continuously quote buy and sell prices near the NAV, and can create or redeem units with the fund manager if the price drifts too far. That arbitrage pulls the price back into line.

But South African investors buying offshore ETFs on the JSE get a twist:

  • Time zones: if the underlying shares trade in New York, they’re closed during much of the JSE trading day. The market maker has to estimate fair value.
  • Currency: the fund’s assets are in dollars, the price is in rands, and the rand moves all day.
  • Liquidity: smaller ETFs with thin trading can see wider spreads and bigger gaps from NAV.

Research on South African ETFs found local-index funds tend to correct gaps quickly, while international ones can hold premiums or discounts for longer, for exactly these reasons.

The MSCI World mystery

Say the MSCI World Index rose 10% in dollars, but your rand-priced MSCI World ETF is up less. Where did the missing slice go?

  • The rand: if the rand strengthened against the dollar, your rand return shrinks. If it weakened, your return grows. This isn’t an error. It’s currency exposure.
  • Dividend timing and withholding tax: foreign dividends get taxed before reaching the fund.
  • Fees and costs.
  • Tracking error.

Tracking error vs tracking difference

These terms are used loosely, but there’s a difference:

  • Tracking difference: the gap between the fund’s return and the index return over a period. If the index made 10% and the fund made 9.7%, the tracking difference is 0.3%.
  • Tracking error: how much that gap jumps around over time. A fund that’s consistently 0.3% behind has low tracking error, even though it lags.

What causes them:

  • Fees: the total expense ratio comes straight off returns. Even small fees compound.
  • Cash drag: dividends sit in cash before being reinvested or paid out.
  • Imperfect replication: some funds hold a sample of the index rather than every share.
  • Rebalancing costs: trading when the index changes.
  • Tax and currency conversion on offshore holdings.

What to check before buying

  1. The total expense ratio and total investment cost.
  2. The fund’s historical tracking difference versus its index.
  3. Trading volume and the typical bid-offer spread.
  4. For offshore ETFs, whether you understand the currency exposure you’re taking.
  5. For REITs, the discount to NAV and why the market might be applying it.

Stokvel Starter Pack

  • NAV: fund value per unit.
  • Premium: trading above NAV.
  • Discount: trading below NAV.
  • Market maker: keeps ETF prices close to NAV.
  • Tracking difference: how far the fund lagged the index.
  • Tracking error: how much that lag varies.

Takeaway: “Just buy the index, bru” is good advice in principle. Just remember even the index gets a hangover: fees, currency and timing all take a sip.

Want the full braai version? Listen on Spotify. And if you’d like the Maze in your inbox, join the free Maze Mail list.

More from The Money Maze

Sources

  1. Precision investing: how close can ETFs get to the index?, Moneyweb.
  2. Profile’s Unit Trusts and Collective Investments, Profile Media, Sep 2024.
  3. Performance evaluation of the tracking ability and pricing efficiency of ETFs in South Africa, Mediterranean Journal of Social Sciences.

This is not financial advice.

Transcript

Read the full transcript

Auto-generated transcript, may contain errors.

Download as plain text (6 KB)

0:00 Welcome back to the Minimise, the podcast for South African retail investors who want to stop feeling like they're drowning in jargon and start navigating the markets like someone who actually knows what they're doing. I'm your host, Jay, and today we're tackling something that confuses more S Africans than low cheating schedules. Why does your ETF or Rite Price look like a one minute, then start behaving like it's a drunk next?

0:25 More especially, why do some of them trade below what they actually worth? And why do you returns never quite match the index? So let's break it down like Brynwood on a Saturday afternoon. If you want the full breakdown on NAV, well, swing back to Episode 5. But here's the short version, perfect for your cousin who still calls ETF SOS money.

0:48 C's nerve stand for net asset value. It's the value of all the stuff the fund owns minus what it owes, divided by how many units are in circulation. So if an ETF holds shares in Apple and Microsoft and Nandos, okay, not Nandos, but I mean, we can dream. NAV tells you what 1 unit of that ETF is technically worth.

1:12 Cool. But here's the twist. The price you see on the market doesn't always match the NAV. And that's not a bug, it's the future we're exploring today. Let's say NAV on a read is 20 Rand per share. You open your investing app, feel like a genius, but wait it's trading at 17 Rand now that's a discount. And yes it feels like a Black Friday special, but is it actually a bargain or are you buying a second hand Hilux with no engine? Years wide discounts in premium happens sentiment. If people love the fund, they willing to pay more than its technically worth and boom you paying a premium. If the vibes are off or the manager's last moves was as questionable as a job book tender, then the price drops below NAV Hello discount.

2:03 Then there's liquidity. If nobody's trading it, especially offshore funds listed in odd places like Ireland or Luxembourg, prices swing harder than your uncle on a Saturday night after a few drops. Then we looking at future expectations. So now is backward looking. It says this is what it's worth based on old valuations. But investors care about the future.

2:26 If that. Read owns UK malls, and UK malls are emptier than a Cape Town Dam in 2018. Investors like bail, causing a drop below the nerve. Bottom line, a discount could mean opportunity, or it could mean warning signs. It's like dating. Don't ignore the red flags just because the packaging looks good. But ETFs are different, right?

2:50 Yes and no. ETFs are usually designed to trade very close to NAV Market makers keep prices aligned by creating or redeeming shares when there's a gap. So why do we still see discrepancies, especially when buying from local mzanzi? Because we're not buying from Wall Street. We're buying through platforms like Easy Equities and often getting exposure to ETFs listed in the UK, the EU, all local rappers in offshore indices.

3:20 Here's what messes things up for us. Timing. NAV is calculated based on what the overseas market closed. But by the time you trade locally, prices may have moved. Currency moves. If the Rand weakens between now of calculation and your purchase, your ETF might look like it's overpriced. Local trading patterns. Well that's Satrix MSCI world ETF. Yep it tracks global stocks but trades on the chaise in rands and the JSC isn't always In Sync with global sentiment. So yes, even ETFs can trade at a discount or a premium when viewed from your local account.

4:00 Not because they broken, but because markets, time zones and currencies don't all speak the same language. So let's use a real example and get a bit spicy. Worthless. You check the MSCI world index and it's up 10% over the last year. You hold a feeder fund ETF in RANDS and it's only up 7.8%. This is the rest of the growth. Some of it got eaten by a weak Rand strengthening, delayed NAV updates, different delays, and that one sneaky villain. Tracking error.

4:34 Now tracking error is what happens when your ETF doesn't perform exactly like the index it tracks. Now before you start writing a complaint letter all in caps, understand it's normal but still annoying. Here's what causes it. Fees. Even cheap ETFs charge management fees. That's 0.15% adds up over a year. Then you've got cash drag. Your ETF gets dividends from Apple or BP or whoever, but those aren't instantly reinvested. That cash sits idle for a while, dragging returns down and then imperfect replication.

5:10 Some ETFs don't buy all the shares in the index. They buy a representative sample, so if one hot stock runs away, they might miss the full benefit. Then there's currency conversion and tax. If you're buying in Rands and the ETF raising dollars or EUR you'll return can fluctuate based on foreign exchange. Plus withholding tax can enable at your dividends like a hungry squirrel. Now throw in a good old local curveball. Most S Africans are accessing these ETFs through platforms that wrap all localise foreign funds like Citrix or Signia. That means you might hold ZR version of a USD ETF. NAV is calculated in foreign currency that you're buying and selling in Rands and you're tracking returns via platform that updates slightly different from global markets. That's like trying to compare pop from 4 different vendors, say my dear, different flavour, different texture, and the consequences will also be different in the next morning. So here's your stock fell start to pack off stock lingo Full volume 19 net asset value the total value of what the fund owns minus what it owes divided by shares premium When the market prices are higher than NAV, discount winner parket price is lower than NAV.

6:33 A tracking error is the gap between your ETFs turn and the index. It's supposed to follow cash drag fees, foreign exchange, and timing. The usual suspects behind performance gaps. So next time someone tells you just buy the index proof, remind them that even the index has a hangover now and then. So while my jokes are more dragged than your offshore ETF, remember this is not financial advice.

6:59 Please do your own research and special licensed advisor. Thanks for tuning in to the Money Maze, and I'll catch you next time.

You might also like

The JSE stories worth knowing about, explained like a mate would at the braai. No hot tips, no spam.

Maze Mail

Listen to The Money Maze