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We have already covered Exchange Traded Funds (ETFs) in detail. But we have not yet talked about how they are priced to keep up with the price of their assets.
A significant difference between ETFs and mutual funds is that we trade ETFs on the stock market. So, people can purchase shares at any time of the day within market hours. It also means that demand and offer could influence the price of ETFs. But in practice, arbitrage is used to make sure the price of the ETFs is synchronized with the underlying assets.
When we talked about Exchange Traded Funds, I mentioned that ETFs used arbitrage to follow the index price. So if the price of the stocks in the index goes up, the ETF price should follow. And if the price of the shares goes down, the ETF price should follow as well. But if the ETF price goes up because of stock market trading, something should correct the price quickly. It is where arbitrage plays a significant role.
In this article, we will see how Exchange Traded Funds are created. And we will see in detail how arbitrage is working and how it makes sure the ETF price stays in sync with the index price. It is a slightly complicated subject. But I think it is good to know exactly how a financial instrument is working before investing in it.
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. It is why the arbitrage mechanism is also called the Creation And Redemption mechanism.
At the beginning of the ETF, the APs buy stock shares (or borrow them) and place them in a trust. Then, the APs use this trust 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. For example, 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 transaction is done as a one-to-one exchange. They receive precisely 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 more creation unit 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.
The problem with ETFs
In practice, you want the fund’s price to be only related to the price of the underlying assets. It should be the same for an ETF or a mutual fund.
Usually, the value of an ETF share should always be synchronized 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. It is reasonably 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. So, the price can go up and down based on the demand of the ETF on the stock market. And these variations can happen regardless of the price of the underlying shares. This difference is, of course, not something that ETF investors want. It is where arbitrage comes into play.
If there is a significant demand to buy ETF shares, it may drive the ETF price 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.
They can buy back some ETF shares in exchange for the underlying stocks at index price. It will drive the ETF price down and drive the price of the underlying stock shares up. The price should be back in sync with the index.
The reverse can happen if there is a large sale 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. They exchange new shares for the underlying shares. This operation 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 usually doing that. Typically, this arbitrage system ensures that the ETF always trades at the fair value of the index. And since APs get a premium for this, it is not challenging to find APs to do the arbitrage job.
The Impact of Arbitrage
As we have seen, the major impact is that Arbitrage brings the price of ETFs back in line when it diverges.
But it may also harm volatility. Each day, there will be many small transactions done by the APs to update the price of the APs. And these transactions will have an impact on the price of some of the stocks.
This impact is not something we should be worried about. There is no such thing as a perfect process. But it can have some effects.
Now, there could be another issue with ETF arbitrage. In case of a stock market crash that is very quick, the ETF may be mispriced by a significant margin. If the automated trading for arbitrage cannot follow the crash fast enough, the mispricing can become considerable. So, this process is not perfect because it takes some time to adjust the prices. So far, significant mispricing has not yet happened, but this could be a thing in the future.
Now you should understand how does the price of an ETF work.
ETF arbitrage is a complex system that makes 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 ETFs 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 arbitrage system? Do you understand it better now?