Let us try to understand them in detail. The AP can then sell the creation units to the open market. Any momentary supply-demand imbalances can be arbitraged away – for example, if there is suddenly less demand for the ETF, and it trades at a discount to the NAV, the AP can buy ETF shares on the open market and redeem them from the ETF fund manager. When the bid of the ETF is higher than … The AP’s primary responsibility is to purchase securities in optimum proportions to replicate the index that the ETF issuer is planning to target. Liquidity providers often use a version of the above calculation to arrive at their own estimates about an ETF’s fair value iNAV. ETF fund managers are seldom the people who buy and sell the securities. Stationary series, as a consequence of the definition, are almost always mean-reverting – wider spreads are more likely to be followed by narrower spreads and vice versa. OTC vs. ETF: Regulatory Arbitrage ... of the Grayscale Bitcoin Trust and simultaneously shorting GBTC on OTC markets at elevated market price premiums to NAV. The classic stat arb strategy is pairs trading, which involves finding two assets that are highly correlated and trading the spread between them. This is a logical requirement – if the statistical properties were changing, nothing stops the spread from widening forever. But ETF arbitrage is advantageous for the arbitrageur and the market. This is the reason why ETF prices fluctuate throughout the day as traders indulge in buying and selling. Mispricings happen in the short term, and these opportunities close within minutes, if not sooner. ETFs are a little bit more complicated. Simultaneously, as the ownership of the ETF increases, the non-fundamental shock of the ETF markets also impacts them. It entails collecting many ETF shares to design a creation unit that he can exchange for underlying securities. For example, if shares of ETF XYZ are trading at $55.00 in the secondary market and the value of the underlying securities is $54.95 per share, there is an inherent arbitrage opportunity. Let’s say $\beta = 2$, in which case we could bet on the spread converging by going long \$10k in the CEF and short \$5k of HYG. This mental model is, in fact, a much better description of CEFs. We can verify that this is indeed a contributing factor by observing that there seems to be a broad negative correlation between asset liquidity and the spread. CEFs have a much lower fraction of institutional ownership than the underlying – it is possible that the pricing of CEFs is less rational as a result, with price movement driven by liquidity and sentiment rather than value. Thus, there is no cash involved and no distribution of capital gains. Creation baskets and redemption baskets for bond ETFs differ on liquidity and maturity aspects. It is comforting that there is a negative sign because it supports the hypothesis that the spread mean-reverts: premiums are correlated with decreasing premiums, discounts are correlated with narrowing discounts. Let us take an example of an ETF that consists of five stocks. By Nhut Nguyen. The exchange-traded funds function on a fair-value basis. The creation and redemption process takes place at the backend. In the long term, the ETF and NAV prices revert back to their shared fundamental value. ETFs or Exchange Traded Funds are securities tracking an index, bond, commodity, or a mix of assets such as an index fund. In general, ETF shares will trade at a premium to NAV when demand is high and at a discount to NAV when demand is low. Secondly, the composition of baskets changes following the changes in relative liquidity and availability of various bonds. In addition to the reasonably high information coefficient, we have a clear economic hypothesis about why the discount to NAV may be a persistent predictive factor. Firstly, it could be due to minor differences in the composition or proportion of basket securities that each ETF uses. What distinguishes an ETF from a mutual fund is that it can trade just like a stock on an exchange. Most traders adopt it as a risk-mitigation mechanism during highly volatile trading conditions. This is quite a decent IC – according to a paper by JP Morgan Equity Research, investors can “achieve significant risk adjusted excess returns with information coefficients between 0.05 and 0.15” (the sign doesn’t matter here). It turns out that although there is not enough statistical evidence to reject the null hypothesis that the spread is non-stationary, the price and NAV are significantly cointegrated (this intuitively means that some linear combination of the price and NAV is stationary). They act swiftly and sell the overpriced index and ETF and buy the underlying stock to earn risk-free profit. With fractional share trading, typically, $1 or $5. Difficulty of arbitrage – in practice, it is hard to lock in a risk-free arbitrage because it may be very difficult to transact in the underlying (which is sometimes why the CEF was created in the first place). The only wrinkle is that the NAV isn’t actually a tradable security. Conversely, CEFs issue a fixed number of shares when they first IPO, and there is no subsequent creation or redemption. As a result, we might expect there to be a larger spread between the CEF price and the NAV (compared with an ETF’s price and its NAV). This article explains and analyses a crucial but understudied aspect of ETF arbitrage that distinguishes equity ETFs from bond ETFs: the nature of ETF baskets. This article explains and analyses a crucial but understudied aspect of ETF arbitrage that distinguishes equity ETFs from bond ETFs: the nature of ETF … Likewise, when ETF prices fall below NAV, APs exchange a "redemption" basket for ETF shares. However, ETFs have an interesting mechanism for ensuring that these deviations between the price and NAV are very short-lived. ETF Arbitrage is a strategy through which traders earn a profit by exploiting the price discrepancy between an ETF and its underlying assets or related securities. There is also no statistically significant relation between the size of arbitrage profits and NAV … The arbitrageur can capture the spread profit while driving the ETF’s market price back in line with its NAV as the arbitrage closes. This doesn’t completely preclude the development of a trading strategy, but it wouldn’t be a proper pairs trade since we would only be acting on one of the legs. This allows an investor to earn an arbitrage profit, minus the This is the mechanism by which premiums or discounts to NAV within ETF pricing are However, the popularity of ETFs among retail and institutional investors for speculative and We can take this a step further and go long the basket and short the individual stock, which results in a risk-free profit once other market participants realise that the basket and the two stocks should be priced identically. ETF arbitrage is thought to aid the market by bringing the market price of ETFs back in line with NAV when divergence happens. In the paper, Ben-David, Franzoni, and Rabih show how ETF arbitrage helps transfer liquidity or price shocks from the ETF to its underlying assets, even when the … This creates an ETF Arbitrage opportunity through which traders can earn profits. A research paper titled ETF Arbitrage, Non-Fundamental Demand, and Return Predictability by David C. Brown, Shaun Davies, and Matthew C. Ringgenberg offers empirical evidence on the theory.