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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.

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