What Is ETF Arbitrage?

 

ETF Arbitrage or ETF Arb is a trading method that takes advantage of price differences between ETFs and the value of the underlying assets. The ETF's NAV may trade at a premium or a discount. 

Because both assets have the same intrinsic worth, the ETF share price should be proportionately equivalent to its underlying portfolio in an efficient market.

Arbitrage possibilities are facilitated by the practice of continuously creating and redeeming new shares of ETFs or Exchange Traded Funds. 

Arbitrageurs profit from mispricing by ensuring that the price of an ETF does not deviate significantly from its net asset value (NAV). They make a risk-free profit in the process.

How ETF Arbitrage Works

ETFs (Exchange Traded Funds) are securities that, like an index fund, follow an index, a bond, a commodity, or a mix of assets. An ETF is different from a mutual fund in that it may be exchanged like a stock on a stock exchange.

As a result, the value of ETFs fluctuates throughout the day as traders buy and sell them. As a result, ETFs benefit from transparent pricing and liquidity.

ETFs, on the other hand, might undergo mispricing since the trading value differs from the underlying net asset value, especially during intraday trade. Traders might profit from ETF Arbitrage as a result of this. 

The arbitrage finally brings the ETF price to the same level as the underlying net asset value, leveling the playing field.

ETF Creation-Redemption Process:

Creation:

When a fund company that issues ETFs wants to launch a new ETF or sell more shares of an existing ETF, they contact an approved participant (AP). An approved participant is generally a significant financial institution. Large investors, brokers, or dealers might be among these APs.

The primary job of the AP is to buy stocks in the best possible amounts to mimic the index that the ETF issuer intends to track. Instead of the underlying securities, the AP receives ETF shares.

Let's look at an example of the creation redemption procedure. For example, let's say an ETF is meant to track the Dow Jones Industrial Average. The Associated Press will buy stock in all Dow Jones Industrial Average components in proportion to their index weight. 

The next stage is for AP to deliver those shares to the ETF supplier, who then gives it an equivalent number of ETF shares. This is referred to as a creation unit. The creation units can then be sold on the open market by the AP.

The exchange-traded funds work on the premise of fair value. When the AP provides a certain number of underlying equities, the ETF shares are valued exactly the same. 

To eliminate any price discrepancies, these shares would be valued using the net asset value (NAV) rather than the market value at which the ETF is now trading. ETF.com has created a beautiful graphic illustration of the ETF formation and redemption method, which you can see below.

Redemption

The next stage is for AP to deliver those shares to the ETF supplier, who then gives it an equivalent number of ETF shares. This is referred to as a creation unit. The creation units can then be sold on the open market by the AP.

The exchange-traded funds work on the premise of fair value. When the AP provides a certain number of underlying equities, the ETF shares are valued exactly the same. 

To eliminate any price discrepancies, these shares would be valued using the net asset value (NAV) rather than the market value at which the ETF is now trading. ETF.com has created a beautiful graphic illustration of the ETF formation and redemption method, which you can see below.

Creation & Redemption Mechanism Benefits

The backside is where creation and salvation take place. It is, nonetheless, quite important. It has a number of advantages for ETF investors, including cheaper costs, more liquidity, and tax efficiency.

ETFs have a bid/ask spread, unlike mutual funds. However, because APs manage their transactions rather than portfolio managers, they continue to charge modest costs.

ETF investors can use the creation and redemption features to reduce their tax liability. The exchange, not the ETF, allows investors to buy and sell shares among themselves. As a result, there is no cash exchanged and no capital gains distribution.

So now that you’re armed with in-depth knowledge about the prospects and workings of ETF arbitrage, you are now all set to invest!

Written By – Devika Mishra