Today, ETFs cover nearly every asset class and make up a significant portion of the trading volume on the exchanges.  It is crucial that we understand the basic elements of these important products, specifically the arbitrage feature, in order to see what makes them unique, efficient, and suited for a wide variety of strategies.

Institutional, professional, and individual investors typically use ETFs in a variety of different investment strategies.  ETFs allow investors to have razor sharp access to parts of the market in an inexpensive and diversified manner.

It is the structure of ETFs that makes this versatility possible.  Traditional ETFs are passive investments, tracking an index.   However, some alternative ETFs have been developed recently that are active and have different structures.  For the plain-vanilla ETF, the objective is to precisely track its index.  In this way, an investor can know intraday the value of the underlying holdings.  This can give insight into the efficiency of the ETF’s management.  The value of the underlying holdings is called the net asset value (NAV) and the intraday holdings value is referred to as the intraday indicative value (IIV).

ETFs trade throughout the day like stocks, while having other characteristics that are mutual fund-like.  Since the underlying holdings can be exactly determined throughout the day, the basket of underlying holdings can be traded and valued extremely efficiently.  In some cases, trading the basket of securities (the ETF) is much more efficient than actually trading the individual holdings- this makes ETFs, with their low expense ratios, a great bargain.  For instance, trading a diversified basket of commodities may be more efficient than going out into the futures exchange and managing a dozen rolling futures contracts.

Since ETFs trade throughout the day and track a market index, there is a built-in arbitrage feature in the structure of ETFs.  Unlike the open-ended mutual fund structure where investors can buy and sell at the NAV, ETFs trade at market prices.   This is similar to a closed-end fund where the fund can sometimes trade at a premium or discount to the NAV or the underlying securities’ value.

The built-in arbitrage feature of ETFs allows market makers, called authorized participants, to buy the basket of underlying ETF holdings on the open market and exchange those shares for ETF shares, profiting from the premium in the ETF market.  In the same way, when ETF shares are trading at a discount to the underlying holdings, market makers can come in, receive the basket of the ETF’s underlying holdings, and pay the discounted price by giving the ETF firm the price that is represented in the ETF market.  These transactions between the market makers and the ETF issuer are done in-kind, meaning that the transactions are done through the exchange of shares and not cash- causing tax consequences to be minimized, which keeps the transactions costs efficient.  Low basis shares are transferred out and high basis shares are transferred in.

 

– Kyle A. WallerWiser Wealth Management