In part 4 of the Investing series, we have covered Exchange Traded Funds (ETF). In this post, I have mentioned that ETF used arbitrage to follow closely the price of the index. If the price of the stocks in the index goes up, the price of the ETF should follow. And if the price of the stocks goes down, the price of the ETF should follow as well. But if the price of the ETF goes up because of stock market trading, something should correct the price quickly. This is where arbitrage plays a big role.
In this post, we are going to see how Exchange Traded Funds are created. And also what is arbitrage? How it makes sure the price of ETF stay in sync with the price of the index. It is a bit of a complicated subject. But I think it is important to know exactly how financial instrument are working before investing in them.
Creation and Redemption
When a manager wants to create an ETF, it needs to find one or several Authorized Participants (APs). An AP can be a financial institution or a large institutional investor. These APs can create or redeem shares of the ETFs. This is why the arbitrage mechanism is also called Creation And Redemption mechanism.
At the beginning of the ETF, the APs buy stock shares (or borrow them) and place them in a trust. This trust is then used to form creation units. A creation unit is a set of stock shares. Generally, a creation unit contains between 10’000 shares and 600’000 shares. The AP then sends these creation units to the ETF company. It is the job of the AP to buy shares in the same way as the index. If a stock is 1% of the index and the AP is creating for 2 million worth of shares, they have to buy 20’000 worth of that stock.
After the ETF company received a creation unit, they will give shares of the ETF to the AP. This is done as a one-to-one exchange. They receive exactly what the shares are worth. Then, the AP can trade the shares of the ETFs on the stock market. If an AP thinks that there is a demand for extra shares, it can repeat the process once again. It creates one creation to receive more shares of the ETF. On the contrary, if the AP wants to reduce the number of shares, it can send back one creation unit to the ETF company. The ETF company will then send back the shares to the AP.
Normally the value of an ETF share should always be on-line with the value of the underlying shares from the index. If the underlying shares go up, the value of the ETF should go up. If the underlying shares go down, the value of the ETF should go down. This is fairly easy to achieve with a mutual fund. But an ETF is exchanged on the stock market. That means that if there is a sudden surge of buyers for the ETFs, it will drive the price up. That means the price can go up and down based on the demand of the ETF on the stock market. Regardless of the price of the underlying shares. This is of course not something that ETF investors want. This is where arbitrage come into play.
If there is a large buy of ETF shares, it may drive the price of the ETF higher than the index. For instance, if the index is at 25, the price of the ETF share may go to 25.20. In that case, the APs come into play. They sell ETF shares at this new price on the open market. At the same time, they buy the underlying stock shares at 25. At the end of the day, they can buy back some ETF shares in exchange for the underlying stocks, at index price. This will drive the price of the ETF down and drive the price of the underlying stock shares up. At the end of the day, the price should be back in sync with the index.
The reverse can happen if there is a large sell of ETF shares. The price of the ETF will be lower than the price of the index. For instance, the price of the ETF could be 24.80 while the index sits at 25. At that point, the AP buys shares of the ETF on the open market. They also sell short the underlying shares. At the end of the day, they exchange the new shares for the underlying shares. This will drive the price of the ETF up and will drive the price of the shares down.
This arbitrage may happen many times a day. Humans are generally not performing this arbitrage. The stock market is moving too fast for this. An automated trading system is generally doing that. Generally, this arbitrage system ensures that the ETF always trade at the fair value of the index.
Now you should understand how does an ETF really work. ETF arbitrage is a complex system that is made to make sure that the price of an ETF is staying in sync with the price of the underlying assets. Some participants are buying and selling the shares of the underlying assets to make sure that the price is correct.
Most of the time, you do not have to worry about this arbitrage mechanism. It always happens under the hood of the system. But it is the reason ETF are matching the price of the index. It is also a reason ETFs are often cheaper than mutual funds. There are fewer taxes and fees for the fund manager this way.
What do you think of this system? Do you understand it better now?