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Can you give me an overview of how ETF arbitrage works? Thanks, M.B.
Arbitrage is a technique that is used to take advantage of price differences.
When it comes to exchange-traded funds, the ability to arbitrage is important, because it helps keep the price at which an ETF is trading in line with the net asset value of the securities it's tracking.
Here's the gist: ETFs track an index, and they generally trade at a price that is close to the net asset value of the underlying stocks in the index. But, because the price of an ETF can also be influenced by investor demand, a fund sometimes ends up trading at a premium or discount to the NAV.
When that happens, the arbitrageurs come in.
The arbitrageurs in this case are usually large brokers or specialists called "authorized participants" who are able to interact directly with the ETFs in a way that other investors can't.
For instance, when the average investor wants to buy or sell an ETF, he does so on the open market, just as with a stock.
Authorized participants, though, have another tool at their disposal.
If they want ETFs, they have the ability to assemble a large portfolio of stocks that represent the underlying stocks in the ETF and exchange them for ETF shares.
Or if they want to dispose of ETFs, they can exchange them for the underlying securities. (This is an oversimplification of the process, but that's the general idea.)
This is where the arbitrage comes in.
If an ETF is trading at a discount, the authorized participant/arbitrageur can gather up ETF shares, exchange them for the underlying stocks and sell the stocks for a profit.
On the flip side, if there's a lot of demand for an ETF and it starts trading at a premium, the authorized participant can buy the underlying stocks, exchange them for ETF shares and then sell the ETFs to generate a profit and reduce the premium.
Here's an easy way to think about it: Say an ETF has 40 underlying stocks, each of which is worth $1.
The NAV of the ETF is $40. But because of investor demand, the ETF starts trading at $41 a share.
If this happens, the authorized participant can buy the underlying stocks, exchange them for ETF shares and sell the ETF shares on the market for a profit. This narrows the gap between the ETF's price and the prices of the underlying stocks.
If the opposite happens and the ETF is trading at $39, a discount to the NAV, the authorized participant can scoop up a bunch of ETF shares, exchange them for the underlying securities and then sell those securities -- again, making a profit and closing the gap.