How ETF Arbitrage Works

Traders, especially high frequency traders, can take advantage of erroneous prices in the market, even if these inefficiencies last only a few minutes or seconds. An evaluation error can occur between two similar titles, such as two S&P 500 ETFsor within the same security, when the trading value differs from the net asset value (NAV).

Market players can exploit both types of inefficiencies by arbitration. Taking advantage of arbitrage opportunities usually involves buying an asset when it is undervalued or trading it at a discount and selling an asset that is overvalued or trading at a premium.

exchange traded funds (ETF) are one such asset that can be traded. ETFs are securities that follow a index, commodity, obligationor basket of assets like an index fund, similar to mutual fund. But unlike mutual funds, ETFs trade like a stock on a stock market. Therefore, throughout the day, ETF prices fluctuate as traders buy and sell stocks. These transactions ensure ETF liquidity and price transparency. However, they also subject ETFs to intraday mispricing, as the trading value can deviate even slightly from the underlying net asset value. Traders can then take advantage of these opportunities.

Key points to remember

  • ETFs have become one of the most popular securities for day traders and offer unique arbitrage opportunities.
  • In addition to traditional index arbitrage, ETFs also lend themselves to low-risk profits from creations or redemptions and pair trading.
  • These strategies, however, can increase market volatility and actually promote inefficiencies such as flash crashes.

ETF Arbitrage: Creation and Redemption

ETF arbitrage can happen in different ways. The most common way is to go through the creation and redemption mechanism. When an ETF issuer wants to create a new ETF or sell more shares of an existing ETF, they contact an authorized participant (AP), a large financial institution that is a market maker or specialist.

The job of the AP is to buy securities in equivalent proportions to mimic the index that the ETF company is trying to mimic, and donate those securities to the ETF company. 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 valuation error. The reverse is done during the redemption process.

The arbitrage opportunity occurs when demand for the ETF increases or decreases the market price, or when liquidity problems induce investors to redeem or demand the creation of additional ETF shares. At such times, price fluctuations between the ETF and its underlying assets lead to valuation errors. The net asset value of the underlying portfolio is updated every 15 seconds during the trading day, so if an ETF is trading at a discount to the net asset value, a company can buy shares of the ETF and then turn around and sell them at net asset value and vice versa if it is trading at a premium.

For example, when ETF A is in high demand, its price exceeds its net asset value. At this point, the AP will notice that the ETF is overvalued or trading at a premium. He will then sell the ETF shares he received upon inception and make a spread between the cost of the assets he purchased for the ETF issuer and the selling price of the ETF shares. He can also enter the market and buy the underlying stocks that make up the ETF directly at lower prices, sell ETF shares in the open market at a higher price and capture the spread.

Although non-institutional market participants are not large enough to play a role in creation or redemption processes, individuals can still participate 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 short (or buy) the ETF. However, liquidity can be a limiting factor, impacting the ability to engage in this arbitrage.

ETF Arbitrage: Trading in Pairs

Another ETF arbitrage strategy is to take a long position in one ETF while simultaneously taking a short position in a similar ETF. It’s called pair swapsand this can lead to an arbitrage opportunity when the price of one ETF is lower than another similar ETF.

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

How does arbitrage affect ETF pricing?

ETF arbitrage is believed to help the market by bringing the market price of ETFs back to net asset value in the event of a divergence. However, questions related to whether ETF 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 actually increase the daily volatility of the underlying stock by up to 3.4%.

Other questions remain as to the extent to which valuation errors can occur between the ETF and the underlying securities when markets experience extreme moves, and whether the benefit of arbitrage, which converges the net asset value and market price, may fail during extreme market movements. For example, during the flash crash in 2010, ETFs were many of the securities that experienced large price declines that also corresponded to large valuation errors that were unrelated to the net asset values ​​of their underlying indices.

What makes the market price of an ETF different from its net asset value?

There are many reasons why an ETF may trade at a premium or discount to its net asset value (NAV). Some of these include liquidity issues, trading in various securities on global markets when national markets are closed, and changes in supply and demand for the ETF itself.

How does ETF arbitrage keep prices close to their net asset value?

ETFs are subject to a process of creations and takeovers, according to which institutional investors and sophisticated traders will simultaneously sell (buy back) ETFs and buy the basket of underlying stocks when the price of the ETF rises too high above the NAV, and they will do the opposite when the market price falls well below the NAV. This ETF arbitrage mechanism tends to keep the price close to the NAV.

How is the net asset value of an ETF calculated?

The net asset value of an ETF is equal to its per share value of the underlying holdings of the ETF’s portfolio less any liabilities.

The essential

ETF arbitrage is not a long-term strategy. Pricing errors happen in the short term and these opportunities close in minutes, if not sooner. But ETF arbitrage is beneficial to the arbitrageur and the market. The arbitrageur can capture the profit from the spread while bringing the market price of the ETF back in line with its net asset value at the close of the arbitrage.

Despite these market advantages, research has shown that ETF arbitrage can increase the volatility of the underlying assets as the arbitrage accentuates or intensifies the mispricing. The perceived increase in volatility requires further research. In the meantime, market participants will continue to benefit from temporary differences between the stock price and the net asset value.