Arbitrage

[Guest]

Critics of ETFs often cite the potential for ETFs to trade at a share price that is not aligned with the underlying securities' value. To help us understand this concern, a simple representative example best tells the story.

Assume an ETF is made up of only two underlying securities:

• Security X, which is worth $1 per share
• Security Y, which is also worth $1 per share

In this example, most investors would expect one share of the ETF to trade at $2 per share (the equivalent worth of Security X and Security Y). While this is a reasonable expectation, it is not always the case. It is possible for the ETF to trade at $2.02 per share or $1.98 per share or some other value.

If the ETF is trading at $2.02, investors are paying more for the shares than the underlying securities are worth. This would seem to be a dangerous scenario for the average investor, but in reality, this sort of divergence is more likely in fixed income ETFs that, unlike equity funds, are invested in bonds and papers with different maturities and characteristics. Also, it isn't a major problem because of arbitrage trading.

The ETF's trading price is established at the close of business each day, just like any other mutual fund. ETF sponsors also announce the value of the underlying shares daily. When the ETF's price deviates from the underlying shares' value, the arbitrageurs spring into action. Here's how arbitrage sets the ETF back into equilibrium. The arbitrageurs' actions set the supply and demand of the ETFs back into equilibrium to match the value of the underlying shares.

Because ETFs were used by institutional investors long before they were discovered by the investing public, active arbitrage among institutional investors has served to keep ETF shares trading at a range close to the underlying securities' value.

Source

[Guest]

 

Arbitrage may be used to bring the market value of an exchange-traded fund (ETF) back into line with the net asset value of the ETF's underlying assets. During the course of the trading day, market price for the ETF naturally fluctuates due to short-term supply and demand forces. If the market price deviates substantially from the net asset value, authorized participants arbitrage differences between those values to bring them back into line. The creation and redemption mechanism is a process by which the market value and net asset value are kept close together.

When an ETF is first created, the issuer enters into an agreement with an authorized participant (AP) who is a larger financial institution. The AP buys the underlying assets represented by the ETF in equivalent proportions to the index the ETF is tracking and places them into large baskets of assets. These asset baskets are then conveyed to the ETF issuer in return for a large block of shares known as a creation unit. Creation units usually contain anywhere from 25,000 to 250,000 ETF shares. The AP can then sell the shares on exchanges or hold on to the shares.

As the ETF shares trade on the exchanges, the price may deviate from the net asset value. This creates arbitrage opportunities for the AP. If the ETF is trading at a premium to the net asset value, the AP can sell shares short in the ETF while buying the underlying assets. At the end of the trading day, the AP delivers the creation basket of underlying assets to the ETF in exchange for more ETF shares. The AP then earns an essentially risk-free profit since its short position is covered by the shares received.

On the flip side, when the ETF is trading below the net asset value, the AP can buy the ETF shares and then sell short the underlying assets. After trading has closed, the AP delivers the shares to the ETF in return for a redemption basket of securities. Once again, the AP makes a virtually risk-free profit by paying less for the ETF shares than it did for the underlying assets. Further, this process reduces the outstanding supply of ETF shares, which helps support the price.

The net asset value is the value of each share's portion of the underlying assets and cash owned by the ETF, including the value of any dividends received. It is calculated on a per-share basis after the end of the trading day. The formula for the net asset value is to add all the ETF's assets including cash, subtracting any liabilities and then dividing that sum by the number of outstanding shares. The net asset value is easily accessible by investors on the ETF issuer's website. The net asset value can also be used as a performance indicator for actively managed ETFs.