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).