Traders, especially high-frequency traders,can take advantage of mispricing in the market even if these inefficiencies last for just a few minutes or even seconds. Mispricing can occur between two similar securities, like two , or within a single security, where the trading value differs from the net asset value (NAV). This process is called ETF arbitrage and it can be legally exploited for profit.
Key Takeaways
- ETFs have become one of the most popular securities for day traders and they provide unique arbitrage opportunities.
- ETFs also lend themselves to low-risk profits from creations or redemptions and pairs trading in addition to traditional index arbitrage.
- These strategies may increase market volatility.
- They can promote inefficiencies such as flash crashes.
Understanding ETFs and Arbitrage
Market participants can exploit several types of inefficiencies through arbitrage. Taking advantage of arbitrage opportunities usually involves buying an asset when it's underpricedor trading at a discount and selling an asset that's overpriced or trading at a premium.
Exchange-traded funds (ETFs) are one such asset that can be arbitraged.ETFs are securities that track an index, commodity, bond,or basket of assets like an index fund, similar to mutual funds. But ETFstradejust like a stockon a market exchange, unlike mutual funds.
ETF prices therefore fluctuate throughout the day as tradersbuy andsell shares. These trades provide liquidity in ETFs and transparency in price but theyalso subject ETFs to intraday mispricing because the trading value can deviate, even slightly, from the underlying net asset value. Traders can then take advantage of these opportunities.
ETF Arbitrage: Creation and Redemption
ETF arbitrage can occur in a couple of ways. The most common way is through the creation and redemption mechanism.An ETF issuer contacts an authorized participant (AP), a large financial institution that is a market maker or specialist, when they want to create a new ETF or sell more shares of an existing ETF.
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. The AP receives shares of the ETF in exchange for the underlying securities. This process is done at the net asset value of the securities, not the market value of the ETF, so there's no mispricing. The reverse occurs during the redemption process.
The arbitrage opportunity occurs 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. Price fluctuations between the ETF and its underlying assets can cause mispricing when this happens.
The NAV of the underlying portfolio is updated every 15 seconds during the trading day. A company can purchase shares of the ETF and then turn around and sell it at NAV, or vice versa if it's trading at a premium and an ETF is trading at a discount to NAV.
A Creation and Redemption Example
ETF A's price rises above its NAV when ETF A is in high demand. At this point, the AP will notice that 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 directly buy the underlying shares that compose the ETF at lower prices then sell ETF shares on the open market at a higher price and capture the spread.
Non-institutional market participants aren't large enough to play a part in the creation or redemption processes but individuals can still partake in ETF arbitrage.They can buy or sell short the underlying securities in the same proportions when ETF A is selling at a premium or discount and sell short or buy the ETF. Liquidity may be a limiting factor, however, impacting the ability to engage in this arbitrage.
ETF Arbitrage: Pair Trades
AnotherETF arbitrage strategy focuses on taking a long position in one ETF while simultaneouslytaking a short position in a similar ETF.This is referred to as pairs trading and it can lead to an arbitrage opportunity when the price of one ETF is at a discount to another similar ETF.
There are several S&P 500 ETFs.Each of these should track the S&P 500), the underlying index, very closely but the intraday prices can diverge at any point. Market participants can take advantage of this divergence by buying the underpriced ETF and selling the overpriced one. These arbitrage opportunities close rapidly so arbitrageurs must 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. But questions related to whetherETF arbitrage increases market volatility have arisen.
A 2018 study titled“Do ETFs Increase Volatility?” by economists Ben-David, Franzoni, and Moussawi examined the impact of ETF arbitrage on the volatility of the underlying securities.They concluded that ETFs can increase the daily volatility of the underlying stock by up to 56 basis points per month.
Other questions remain about the extent to which mispricing can occur between the ETF and underlying securities when markets experience extreme moves, and whether the benefit from the arbitrage may fail during extreme market moves which cause NAV and market price to converge. Many ETFs saw big price declines during the flash crash in 2010. According to the SEC, 27% of 838 ETPs were temporarily "unhinged from their underlying securities pricing."
ETPs include ETFs and exchange-traded notes (ETNs).
The SEC noted that hundreds of ETFs have a daily trading volume of less than one million shares per day. This low liquidity poses a risk for traders who must execute quickly and precisely.
Risk of ETF Arbitrage
Liquidity risk is among the primary concerns in ETF arbitrage. An arbitrageur must buy or sell the underlying assets when they seek to create or redeem ETF shares. They may not be able to get favorable prices if these underlying assets have low trading volumes. Limited liquidity can stop your ability to execute trades quickly so you may miss out on opportunities if prices move quickly against the arbitrageur.
The arbitrage process involves a series of precise steps, each being necessary to create and then redeem the ETF shares. Any delays or mistakes during this process can result in execution risk. You may be stuck with assets at unfavorable prices if you mess up creating or redeeming ETF shares or have issues exchanging ETF shares for underlying assets.
ETF arbitrage relies on price disparities between the ETF and its underlying assets. Arbitrage can't exist without these disparities. The entire structure of ETF arbitrage would be in jeopardy due to sharp movements by markets. There's an underpinned market risk in the entire process that outcomes beyond a trader's control as a result. There's always the chance that markets will consume the difference faster than how an arbitrageur can capture it.
It's also important to consider regulatory risk. The SEC is always evaluating trading, liquidity, or investing practices to guide the best policies. Shifts in tax regulations can influence the tax treatment of gains and losses from ETF arbitrage, potentially affecting the after-tax profitability of the strategy. Preventative measures from the regulators may also prevent a trader from facilitating various aspects along the arbitration process.
What Causes an ETF's Market Price to Differ From Its NAV?
An ETF may trade at a premium or discount to its net asset value (NAV) for many reasons. Some of these include liquidity issues, trading in various securities in global markets when domestic markets are closed, and changes in the supply and demand for the ETF itself.
How Does ETF Arbitrage Keep Prices Close to Their NAV?
ETFs are subject to a process ofcreations and redemptions in which institutional investors and sophisticated traders will sell or redeem ETFs and simultaneously buy the basket of underlying stocks when the ETF price rises too high above the NAV. They'll do the opposite when the market price falls well below the NAV. This mechanism of ETF arbitrage tends to keep the price close to the NAV.
How Is the NAV of an ETF Calculated?
The net asset value of an ETF is equal to its per-share value of the underlying holdings in the ETF's portfolio less any liabilities.
The Bottom Line
ETF arbitrage isn't a long-term strategy. Mispricing happens 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.
Research has shown that ETF arbitrage may increase the volatility of the underlying assets despite these market advantages because the arbitrage emphasizes or intensifies the mispricing. The perceived increase in volatility needs further research. Market participants will continue to benefit from temporary spreads between share price and NAV in the meantime.
