ETF Capital Markets Desk: About Arbitrage

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    What does buying and selling books and baubles on popular Internet shopping sites have to do with exchange-traded funds (ETFs)? While you can’t buy or sell an ETF on such sites (not yet anyway), David Mann, our head of capital markets, Global Exchange-Traded Funds (ETFs), uses the concept of making transactions on these sites to illustrate arbitrage in the realm of ETFs.

    In my last post, we talked about an exchange-traded fund’s (ETF’s) fair value and its role within the price discovery process. I mentioned ETF arbitrage also has a role to play in any discussion on the price of US-listed ETFs that hold international securities. Thus for this effort, I want to kick off a discussion on ETF arbitrage. Just so you are forewarned, this might take a couple of posts.

    First, let’s start with the basic concept of “arbitrage,” which is to buy and sell the same thing at the same time at two different prices. While the term “arbitrage” may sound scary, it serves a useful purpose in ensuring the price stays of the ETF stays in line with price of its underlying securities.

    The idea is to try to take advantage of the price discrepancy of these identical (or nearly identical) products selling in different markets or platforms. Within the realm of finance and investing, arbitrage keeps prices in alignment, and there are entire businesses dedicated to finding and seeking to exploit arbitrage opportunities.

    So arbitrage is not a concept unique to ETFs. Some time ago I even read an article about people who simultaneously buy/sell things on two different online shopping sites at different prices—finding a product at a lower price on one platform then turning around and quickly selling it at a higher price on another, netting profit from the price spread. This type of transaction is a good illustration of the concept of arbitrage when it comes to ETFs.

    For ETF arbitrage, there are two main points I want to stress:

    • The ETF and its underlying basket are one in the same.

    I have to admit that sometimes this concept gets lost in the trees with all of the discussion on creation/redemption mechanisms, daily transparency, portfolio composition files (PCFs), ETF liquidity etc., which I won’t dive into here (search for these terms online if you wish).

    The reason we can use the word “arbitrage” for ETFs is because the ETF and its basket can be considered the same thing. The ETF is simply a wrapper of a bunch of underlying stocks, and the ETF and the basket can be exchanged for each other at any time.

    • Even though they are the “same” thing, there are different costs associated with buying/selling both the ETF and its basket.

    Let’s go back to the online shopping example. Suppose I find a book I could buy on one website for $10 and sell on the other for $11. Have I made a riskless $1? Well, that depends. Are there any sales taxes associated with buying the book? Do I have to pay a delivery fee? Is there an annual membership fee at one or both of those web sites? Do I need a warehouse to store the books I bought before I sell them?

    These types of costs have to get factored into any arbitrage trade, whether with online retail transactions or with ETFs.

    Let’s explore an ETF example using some arbitrary (pun intended) prices:

    ETF market:  99.98 (bid) x 100.02 (ask)

    ETF intraday net asset value (NAV) = $100

    So the usual ETF arbitrage sound bite says the ETF market maker can buy the basket at $100 and sell the ETF at $100.02 and make a riskless $0.02.

    But buying the basket at $100 does not exist in a vacuum.

    • Each of those underlying stocks has its own bid/ask
    • Strong demand could impact the prices of those underlying stocks differently.
    • There is a cost if the Authorized Participant wants to exchange that basket for ETF units (creation fee)
    • Some markets have stamp taxes (e.g., Hong Kong, United Kingdom) or sales taxes (e.g.,Taiwan, South Korea). The latter adds an extra wrinkle as the costs to buy and sell the basket might be different.
    • There could be additonal costs for holding ETFs for an extended period of time

    So when thinking about ETF arbitrage, it is important to understand all the costs associated with buying (and selling) the underlying basket. These two numbers form an ETF’s arbitrage band and are very important in driving the intraday price of an ETF.

    I’ll stretch out this topic further in my next post, when I dive into ETF bands.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    This information is intended for US residents only.

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    What Are the Risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.