How the market keeps ETF prices in balance

Investors often find it difficult to visualise how an ETF’s market price trades close to its net asset value. But market forces stop ETF prices deviating too far from their intrinsic value.

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Like all listed securities, prices of ETFs fluctuate over the day which can result in them trading at a small premium or discount to true net asset value (NAV). However, unlike normal funds, the intraday net asset value (iNAV) of an ETF is updated every 15 seconds, giving market makers the ability to react very quickly to mispricing.

Investors who try to buy undervalued ETFs and sell them when they look overvalued will find that it is a very difficult strategy to consistently make money from. A lack of profitable opportunities for arbitrageurs (traders that seek a riskless profit) is one of the key attractions of ETFs – the fact that investors can be confident that they are able to transact at a fair price under nearly all circumstances has been a key reason behind the growth of the industry.

Here are the tools that market participants, both institutions and individuals, have at their disposal to keep ETF prices in check. 

1. Creation and redemption by market makers

Working behind the scenes of every ETF are competing authorised participants (APs) and market makers, who have the ability to deliver securities to the ETF provider in exchange for ETF units when the ETF is over-priced, or to redeem ETF units in exchange for cash when it is underpriced. 

This is commonly referred to as the Arbitrage Pricing Mechanism (APM). Essentially, it means that if the NAV of an ETF is £100, and the ETF is trading in the market at £101 (a premium of 1%) a market maker can buy the underlying stocks in the market for £100, sell them to the ETF provider and make a £1 profit through selling their new holding in the ETF. The opposite is true if the ETF sells at a discount to its true NAV.   

In reality there is more to take into consideration than this, which is why ETFs’ prices typically fluctuate within a range around their NAV.

The ETF market maker that creates and redeems ETF units cannot profit from every deviation from net asset value as there are costs to their trading.

  • The ETF has a bid/ask spread
  • There may be taxes to pay to buy the underlying holdings
  • For regularly traded ETFs, the bid/ask spread is often tighter than the bid/ask spread of all the underlying portfolio holdings. For example the iShares Core £ Corporate Bond ETF has a bid/ask spread of 0.25%, while the underlying bonds trade with a spread of 0.81% (Source: iShares 14.11.2016)
  • Minimum lot sizes to create and redeem ETF units, making some profits too small to chase
  • The underlying market may be too illiquid, or open at a different time of day (e.g. the S&P 500 trades at a different time to the London Stock Exchange, meaning the market maker cannot always buy/sell the underlying shares to realise a profit).
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Figure 1: Premium / Discount trading mechanism Source: IG, May 2017

2. Pair trading: long and short

Regular investors can also theoretically arbitrage pricing anomalies if they see them. If the ETF was trading at a discount, rather than creating and redeeming ETF units, they could buy the ETF and short the stocks within the ETF. The disadvantage of this is that it requires large amounts of capital to do this, as well as technical expertise.

3. ETF pair trading

An easier way to arbitrage ETF prices is through ETF pair trading, which can be done by simultaneously taking a long positon in one ETF (e.g. the Vanguard FTSE 100 ETF - VUKE) and a short position in another (e.g. the Source FTSE 100 ETF – S100 ). By selling the overpriced ETF and buying the underpriced ETF the investor would be able to profit when those prices converge.

Conclusion

With sophisticated computer algorithms and market makers consistently seeking to profit from ETF mispricing, they act in the investor’s favour by increasing ETF trading volumes which lowers the costs investors face from bid/ask spreads. By forcing ETF prices back in line with NAV, investors are less likely to sell their investment at a discount to NAV and to buy at a premium to NAV, which allows them to track the underlying index in a more efficient manner.

In times of extreme market stress, ETF prices could still move away from intrinsic value. While not ideal, it does serve a purpose: investors that really need to sell will find a buyer at a price they see on screen, whereas holders of unit trusts have to submit their trade instruction a day early, have no price visibility, and may – in an extreme scenario - find that fund redemptions are suspended.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.