ETF Capital Markets Desk: Expanding on Arbitrage Bands

    David Mann

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

    David Mann, our head of capital markets, Global Exchange-Traded Funds (ETFs), dives deeper into the subject of arbitrage as it applies to ETFs. In his latest post, he expands on the topic of arbitrage bands.

    In my last post, I introduced the concept of arbitrage within the realm of exchange-traded funds (ETFs). To recap, arbitrage involves buying and selling essentially the same thing at the same time at two different prices in attempt to take advantage of the price discrepancy between these identical (or nearly identical) products selling in different markets or platforms.

    I also touched on ETF arbitrage bands, a topic which I think is worth expanding upon here. 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. The “left side” of the band would be the total cost for an Authorized Participant (AP) to redeem shares of an ETF while the “right side” of the band would be the total cost for an AP to create shares of an ETF. It should look something like the example below.

    The ETF basket is worth $100.

    The ETF bid/ask spread is $99.98 x $100.02.

    The redemption band is $99.95 and the creation band is $100.05.

    I would not expect an individual investor to know the exact arbitrage band for each ETF before making his or her investment decision. However, often decisions on what ETF to use to gain exposure to a particular asset class are driven by metrics which can be flawed, such as average daily volume or bid/ask spread. Understanding the price of an ETF in relation to its arbitrage bands will give a more accurate reflection of the total cost of using a particular ETF. Let’s touch on a couple of those topics here:

    Different asset classes will have different arbitrage bands.

    Even though the spreads of an ETF may look the same, their arbitrage bands can and will be quite different. As I touched upon in my prior blog, a lot of factors go into these bands including the spread of the basket, local stamp taxes, creation/redemption fees, etc. There could be the occasional exception, but at a high level:

    1. ETFs that hold large-capitalization stocks will have tighter bands than those that hold mid-capitalization stocks, which will have tighter bands than those that hold small-capitalization stocks.
    2. ETFs that hold US stocks will have tighter bands than those that hold developed-market international stocks, which will have tighter bands than those that hold emerging-market stocks.

    0917_ETF_Arbitrage_1

    The ETF will tend to be closer to the creation arbitrage band when there is buying pressure and be closer to the redemption arbitrage band when there is selling pressure.

    What makes this one tricky is that the actual spread of the ETF will be the same in both cases. Let’s look at the sample ETF arbitrage band in the image prior. As it is shown there, the ETF is trading right in the middle of the arbitrage band. However, if there was buying pressure in the market, one would expect the ETF to move toward the creation band, and the spread might be $100.01 x $100.05.

    0917_ETF_Arbitrage_2

    Likewise, if there is selling pressure, one would expect the ETF to move the other way. For example, $99.95 x $99.99. In this example, the moves are driven by buying/selling pressure and not necessarily a change in the price of the ETF’s underlying basket of stocks, which has stayed the same.

    0917_Arbitrage_3

    ETFs will tend to trade inside those bands but could potentially trade outside of them.

    By naming them ETF arbitrage bands or calling them goalposts, there is almost an implication that the ETF should not trade outside those bands. That is simply not the case. ETFs are subject to the same market forces as any other listed security. If there is extreme buying or selling pressure, it is very possible the ETF will trade outside those bands.

    Even though they both drive the price of US ETFs with underlying international stocks, the arbitrage bands should not be confused with price discovery.

    The arbitrage bands are the range between buying and selling the underlying basket, and the bands tend to be fairly constant. Price discovery is the expectation of what the US market thinks will happen when those closed international markets (where the underlying stocks trade) reopen the next day. This expectation tends to fluctuate based on what is happening during the US trading session. These two forces can move together (strong US session with lots of buying pressure in the ETF) or not (strong US session with lots of selling pressure of the ETF).

    Once again, the point of this exercise is not to confuse! Hopefully if you’re still with me, you can appreciate how easy it generally is to buy and sell ETFs of any underlying asset class.

    However, as investors ask deeper questions on ETF liquidity and what drives the market price of international ETFs, understanding the above can help better explain all the costs of owning a particular ETF.

    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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