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In the stock market, the prices of securities are generally determined by the forces of supply and demand. But sometimes prices deviate significantly from the actual value of the asset and this results in arbitrage opportunities. This higher discrepancy in the price and value of assets can lead to significant losses for small investors. That is why efficient pricing is very important in financial markets.
As ETFs are also traded on exchanges, they are also susceptible to inefficient pricing. To avoid this situation, multiple entities work simultaneously. Let’s discuss how this is done in more detail.
As we know, ETFs rarely trade at a discount or a premium to their NAV. The process of creation and redemption described here is responsible for making sure that the market price of ETFs does not deviate too much from the underlying value.
Let’s understand how this works in more detail. Since an ETF trades like a stock, its price will fluctuate throughout the day due to supply and demand.
Suppose many investors want to buy this ETF. Its price might rise above the value of its underlying securities. When this happens, Authorised Participants (APs) see an arbitrage opportunity. AP will buy up the underlying securities of the ETF. If AP already has the inventory, it can sell the overpriced ETF and pocket away the arbitrage profit. If there is no inventory, AP can use the creation mechanism to create new ETF units and sell them. As AP sells the ETF units, it drives down the price back to NAV.
The reverse is also true. Suppose an AP sees that an ETF is trading at a significant discount to NAV. It can mop up ETF units in creation unit size, exchange it with underlying security (using the redemption mechanism) and sell the underlying securities. Buying ETF units pushes the price back up to NAV.
In both cases, AP pockets away the arbitrage profit. When there are multiple APs behind an ETF, prices generally tend to stay in line with the value of underlying securities. This happens because multiple institutions actively look for arbitrage opportunities at the same time. And this eventually increases the efficiency of the pricing process.
The diagram below gives a visual representation of the process.
One of the problems with ETFs in India is the absence of multiple active APs (as well as market makers). In a developed economy like the US, typically, every ETF has over 30 APs and at least 5 APs are active at any given point in time. In India, only large ETFs have 5 or more APs and only a few are active at any given point in time.
We will discuss the role of AP and market markers more in one of our next articles on ETF Liquidity.
The bid-ask spread can affect the price of an ETF by increasing the transaction costs of buying or selling the ETF units. Investors should consider the bid-ask spread when evaluating the total cost of owning an ETF.
Yes, an ETF can trade at a significant premium or discount to its NAV, especially in volatile or illiquid markets. In the event that significant price deviations are observed, ETF issuers and APs may use mechanisms such as creation/redemption processes to help maintain the market price of the ETF in line with the NAV.