Understanding ETF Arbitrage: Process and Impact on Market Volatility

ETF arbitrage involves profiting from price differences between an ETF and its underlying assets. It occurs through creation and redemption, where traders swap shares for the underlying assets, or vice versa, to bring prices back in line. High-frequency traders capitalize on these opportunities, helping align prices but sometimes contributing to market volatility and liquidity concerns. Although available to individual investors, ETF arbitrage is generally more accessible to institutional investors because of the execution speed and liquidity needed to make it profitable.

Exploring ETFs and Arbitrage Opportunities 

Market participants can exploit several types of inefficiencies through arbitrage. Taking advantage of arbitrage opportunities usually involves buying an asset when it's underpriced or trading at a discount and selling an asset that's overpriced or trading at a premium.

Exchange-traded funds (ETFs) are one such asset that can be arbitraged. ETFs are securities that track an index, commodity, bond, or basket of assets like an index fund, similar to mutual funds. But ETFs trade just like a stock on a market exchange, unlike mutual funds.

ETF prices therefore fluctuate throughout the day as traders buy and sell shares. These trades provide liquidity in ETFs and transparency in price but they also subject ETFs to intraday mispricing because the trading value can deviate, even slightly, from the underlying net asset value. Traders can then take advantage of these opportunities.

How Creation and Redemption Drive ETF Arbitrage

ETF arbitrage can occur in a couple of ways. The most common way is through the creation and redemption mechanism. An ETF issuer contacts an authorized participant (AP), a large financial institution that is a market maker or specialist, when they want to create a new ETF or sell more shares of an existing ETF.

The AP’s job is to buy securities in equivalent proportions to mimic the index the ETF firm is trying to mimic and give those securities to the ETF firm. The AP receives shares of the ETF in exchange for the underlying securities. This process is done at the net asset value of the securities, not the market value of the ETF, so there's no mispricing. The reverse occurs during the redemption process.

The arbitrage opportunity occurs when demand for the ETF increases or decreases the market price, or when liquidity concerns cause investors to redeem or demand the creation of additional ETF shares. Price fluctuations between the ETF and its underlying assets can cause mispricing when this happens.

A Creation and Redemption Example

ETF A's price rises above its NAV when ETF A is in high demand. At this point, the AP will notice that the ETF is overpriced or trading at a premium. It will then sell the ETF shares it received during creation and make a spread between the cost of the assets it bought for the ETF issuer and the selling price from the ETF shares.

It may also go into the market and directly buy the underlying shares that compose the ETF at lower prices then sell ETF shares on the open market at a higher price and capture the spread.

Non-institutional market participants aren't large enough to play a part in the creation or redemption processes but individuals can still partake in ETF arbitrage. They can buy or sell short the underlying securities in the same proportions when ETF A is selling at a premium or discount and sell short or buy the ETF. Liquidity may be a limiting factor, however, impacting the ability to engage in this arbitrage.

Pair Trading: An Effective ETF Arbitrage Strategy

Another ETF arbitrage strategy focuses on taking a long position in one ETF while simultaneously taking a short position in a similar ETF. This is referred to as pairs trading and it can lead to an arbitrage opportunity when the price of one ETF is at a discount to another similar ETF. 

There are several S&P 500 ETFs. Each of these should track the S&P 500), the underlying index, very closely but the intraday prices can diverge at any point. Market participants can take advantage of this divergence by buying the underpriced ETF and selling the overpriced one. These arbitrage opportunities close rapidly so arbitrageurs must recognize the inefficiency and act quickly. This type of arbitrage tends to work best on ETFs with the same underlying index.

The Effect of Arbitrage on ETF Pricing and Volatility 

ETF arbitrage is thought to aid the market by bringing the market price of ETFs back in line with NAV when divergence happens. But questions related to whether ETF arbitrage increases market volatility have arisen.

A 2018 study titled “Do ETFs Increase Volatility?” by economists Ben-David, Franzoni, and Moussawi examined the impact of ETF arbitrage on the volatility of the underlying securities. They concluded that ETFs can increase the daily volatility of the underlying stock by up to 56 basis points per month.

Other questions remain about the extent to which mispricing can occur between the ETF and underlying securities when markets experience extreme moves, and whether the benefit from the arbitrage may fail during extreme market moves which cause NAV and market price to converge. Many ETFs saw big price declines during the flash crash in 2010. According to the SEC, 27% of 838 ETPs were temporarily "unhinged from their underlying securities pricing."

ETPs include ETFs and exchange-traded notes (ETNs).

Understanding the Risks Involved in ETF Arbitrage

Liquidity risk is among the primary concerns in ETF arbitrage. An arbitrageur must buy or sell the underlying assets when they seek to create or redeem ETF shares. They may not be able to get favorable prices if these underlying assets have low trading volumes. Limited liquidity can stop your ability to execute trades quickly so you may miss out on opportunities if prices move quickly against the arbitrageur.

The arbitrage process involves a series of precise steps, each being necessary to create and then redeem the ETF shares. Any delays or mistakes during this process can result in execution risk. You may be stuck with assets at unfavorable prices if you mess up creating or redeeming ETF shares or have issues exchanging ETF shares for underlying assets.

ETF arbitrage relies on price disparities between the ETF and its underlying assets. Arbitrage can't exist without these disparities. The entire structure of ETF arbitrage would be in jeopardy due to sharp movements by markets. There's an underpinned market risk in the entire process that outcomes beyond a trader's control as a result. There's always the chance that markets will consume the difference faster than how an arbitrageur can capture it.

It's also important to consider regulatory risk. The SEC is always evaluating trading, liquidity, or investing practices to guide the best policies. Shifts in tax regulations can influence the tax treatment of gains and losses from ETF arbitrage, potentially affecting the after-tax profitability of the strategy. Preventative measures from the regulators may also prevent a trader from facilitating various aspects along the arbitration process.

The Bottom Line

ETF arbitrage takes advantage of short-term market inefficiencies when an ETF’s price diverges from its NAV. This process helps bring prices back in line, benefiting traders and market efficiency. But while ETF arbitrage corrects mispricing, research suggests it may also contribute to increased volatility in the underlying assets. Despite these potential drawbacks, arbitrage remains essential for maintaining fair and efficient markets.