How ETF Arbitrage Works

how etf works

Market traders, especially high frequency traders take advantage of mispricings in the market, even if these inefficiencies last for just a few seconds or minutes. Mispricing can occur between two similar securities, like two S&P 500 ETFs. or within a single security, where the trading value differs from the net asset value (NAV). Both types of inefficiencies can be exploited by market participants through arbitrage. Taking advantage of arbitrage opportunities usually involves buying an asset when it is underpriced or trading at a discount and selling an asset that is overpriced or at a premium.

Exchange traded funds. or ETFs, are one such asset that can be arbitraged. ETFs are securities that track an index. commodity. bond. or a basket of assets like an index fund, similar to mutual funds. But unlike mutual funds, ETFs trade, just like a stock, on a market exchange. Therefore, throughout the day, ETF prices fluctuate as trades are made to buy or sell shares. These trades provide liquidity in ETFs and transparency in price, but they also subject ETFs to intraday mispricing as the trading value can deviate, even slightly, from the underlying net asset value. Traders then take advantage of these opportunities.

ETF Arbitrage: Creation and Redemption

ETF arbitrage can occur in couple of different ways. The most common is through the creation and redemption mechanism. When an ETF issuer wants to create a new ETF or sell more shares of an existing ETF, he contacts an authorized participant (AP), a large financial institution that is a market maker or specialist. The AP’s job is to buy securities in equivalent proportions to mimic the index the ETF firm is trying to mimic, and give those securities to the ETF firm. In exchange for the underlying securities, the AP receives shares of the ETF. This process is done at the net asset value of the securities not the market value of the ETF so there is no mispricing. The reverse is done during the redemption process.

The arbitrage opportunity happens when demand for the ETF increases or decreases the market price, or when liquidity concerns cause investors to redeem or demand the creation of additional ETF shares. At these times, price fluctuations between the ETF and its underlying assets cause mispricings. The NAV of the underlying portfolio is updated every 15 seconds during the trading day, so if an ETF is trading at a discount to NAV, a company can purchase shares of the ETF then turn around and sell it at NAV and vice versa if it is trading at a premium.

For example, when ETF A is in high demand, its price rises above its NAV. At this point the AP will notice the ETF is overpriced or trading at a premium. It will then sell the ETF shares it received during creation and make a spread between the cost of the assets it bought for the ETF issuer and the selling price from the ETF shares. It may also go into the market and buy the underlying shares that compose the ETF directly at lower prices, sell ETF

shares on the open market at the higher price, and capture the spread.

While non-institutional market participants are not large enough to play a part in the creation or redemption processes, individuals can still partake in ETF arbitrage. When ETF A is selling at a premium (or discount), individuals can buy (or sell short) the underlying securities in the same proportions and sell short (or buy) the ETF. Liquidity may be a limiting factor, impacting the ability to engage in this arbitrage.

ETF Arbitrage: Pair Trades

A different ETF arbitrage strategy focuses on buying or taking a long position in one ETF while simultaneously selling short or taking a short position in a similar ETF. This is called pair trading and can lead to an arbitrage opportunity when the price of one ETF is at a discount to another similar ETF.

For example, there are several S&P 500 ETFs. Each of these ETFs should track the underlying index (S&P 500) very closely but at any given point, the intraday prices can diverge. Market participants can take advantage of this divergence by buying the underpriced ETF and selling the overpriced one. These arbitrage opportunities, like the previous examples, close rapidly so arbitrageurs need to recognize the inefficiency and act quickly. This type of arbitrage tends to work best on ETFs with the same underlying index.

How Does Arbitrage Impact ETF Pricing?

ETF arbitrage is thought to aid the market by bringing the market price of ETFs back in line with NAV when divergence happens. However, questions related to whether or not ETF arbitrage increases market volatility have arisen. A 2014 study. “Do ETFs Increase Volatility?” by Ben-David, Frazoni, and Moussawi, examined the impact of ETF arbitrage on the volatility of the underlying securities. They concluded that ETFs can increase daily volatility of the underlying stock by 3.4%.

Other questions remain about the extent of mispricing that can occur between the ETF and underlying securities when markets have extreme moves and whether the benefit from the arbitrage, which causes NAV and market price to converge, may fail during extreme market moves. For example, during the Flash Crash in 2010, ETFs made up many of the securities that saw large price declines and also experienced temporary mispricing of greater than 10% from the underlying index. Although this is an isolated occurrence in which ETF arbitrage may have temporarily increased volatility or had unintended consequences, additional research is warranted.

The Bottom Line

ETF arbitrage is not a long-term strategy. Mispricings happen in the short-term and these opportunities close within minutes if not sooner. But ETF arbitrage is advantageous for the arbitrageur and the market. The arbitrageur can capture the spread profit while driving the ETF’s market price back in line with its NAV as the arbitrage closes. Despite these market advantages, research has shown that ETF arbitrage may increase volatility of the underlying assets as the arbitrage emphasizes or intensifies the mispricing. The perceived increase in volatility needs further research. In the meantime, market participants will continue to benefit from temporary spreads between share price and NAV.


Category: Forex

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