One of the most frequently mentioned benefits of ETFs is liquidity – the ability for investors to buy and sell at any time throughout the trading day. In companion articles in the BetaShares Academy we have described how the liquidity of ETFs is managed – that is, by the inter-linked concepts of “Market Making” and “Creation and Redemption of ETF Units”. To fully understand how ETF market makers interact with the ETF issuer, we need to also understand the concept of “arbitrage”. It’s through the function of the market-maker and the process of “arbitrage” that ETF prices are kept at, or close to, fair value and which contributes to overall ETF market liquidity.
What is arbitrage?
Now “arbitrage” is an often poorly understood concept – but its meaning is very simple to understand. Wiktionary defines “arbitrage” as:
“…the possibility of a risk-free profit at zero cost. For instance, an arbitrage is present when there is the opportunity to instantaneously buy low and sell high.”
We can illustrate the concept of arbitrage with a simple example. Large companies might have their shares listed on the ASX, as well as another exchange such as the London or New York Stock Exchange (this is known as “dual listing” and works to give offshore investors the ability to trade during their own business hours). The shares listed in the UK or US are the same class/type of shares as those listed in Australia – and therefore they should normally always trade at the same price (at the same time).
Now think of the scenario where both ASX and London Stock Exchange (LSE) are open at the same time (eg late in the day in Australia and early in the day in the UK). Imagine that a very large buy order is placed on the LSE and this tends to increase the price of the dual-listed shares in the UK market. At the same time, the price of dual-listed shares hasn’t moved in the Australian market.
In this example, an “arbitrage” opportunity will exist because an investor could simultaneously buy shares in Australia and sell the same shares (for a profit) in the UK. This is a great example of “simultaneously buying low and selling high.”
Arbitrage is considered to be “good” for the market because the existence of an arbitrage opportunity tends to very quickly trigger transactions which restore equilibrium to prices. In the dual-listed example above, the investor who buys shares in Australia will tend to drive the (Australian) price of shares up; simultaneously selling them in London will tend to drive the (UK) price of shares down.
The result? Assuming an efficient market, the price of the shares in the UK and Australia will tend to converge so that the UK price and Australian price are similar – and they should be: after all, they are shares in the same company!
Arbitrage works similarly in the ETF market, to level out any price discrepancies between the units of the fund and the bundle of shares or assets comprising it.
Because an ETF is simply a fund which buys and holds shares (or other assets) that are components of an index, the price of the ETF should be the same as the sum of those component assets. But as with dual listed shares, occasionally this is not the case.
If investors decide to sell or buy a large quantity of ETF units on the ASX, then similar to the previous example, this could push the price of the ETF away from the value of the component shares that comprise the index. In this case, the ETF market maker can approach the issuer to either redeem or create more ETF units, which will lead to the ETF issuer selling or buying the component shares in the underlying share market (for instance, the ASX).
In this simple example, imagine an ETF unit whose component shares are worth $10, in which case the “fair value” of the ETF unit should also be $10. If the temporary increase in supply of the ETF units (because many investors are selling their ETF units at once) pushes the ETF price on the ASX down to $9.95, the market maker can achieve an arbitrage profit by:
- Buying ETF units for the listed price of $9.95 on the ASX
- Redeeming those units directly with the ETF issuer
The ETF issuer will sell the component stocks for a price of $10 and cancel the ETF units, paying the $10 back to the market maker.
In this example, the market maker has enjoyed an arbitrage profit of $0.05, for a matched trade with no risk.
Because these arbitrage opportunities exist, ETF prices should remain very close to the “net asset value” of the ETF, ultimately for the benefit of you as the investor.
Just as in the BHP example where we showed that arbitrage has the beneficial result of bringing prices back to equilibrium, in the ETF example a similar short term price disparity between the ETF units and component stocks will normally trigger market making activity, which will bring the two sets of prices back into line and allow excess supply or demand to be absorbed.
Hence “arbitrage” can be seen as a fundamental contributor to the liquidity in the ETF market – important for all investors who look to ETFs as an investment vehicle they can easily move into and out of.