Exchange traded funds have a so-called arbitrage mechanism that helps keep share prices in line with the value of the underlying securities or assets.
Arbitrage is the practice of taking advantage of a price difference between two or more markets.
Three points about ETFs and the arbitrage trading mechanism:
- Shares of ETFs can be created or redeemed in large blocks by so-called authorized participants, usually financial institutions. [What is an ETF: Premiums and Discounts]
- Arbitrage actually sets the trading price of an ETF back into balance, reports James McWhinney of Investopedia. The trading price and the value of underlying shares of an ETF are announced each day, so when the price of an ETF deviates from the value of the underlying shares, arbitrageurs get into action. If the underlying securities are trading at a lower price than the ETF shares, arbitrageurs buy the underlying securities, redeem them for creation units, and then sell the ETF shares on the open market for a profit.
- If the underlying shares are trading over the market value of the ETF, arbitrageurs buy ETF shares on the open market and form creation units. Then they redeem the creations units to get the underlying shares and sell the shares on the open market for a profit. [All About ETFs and Liquidity]
Arbitrageurs are actually setting the supply and demand of the ETFs back into equilibrium and ensure they trade in line with the value of the underlying shares, or close to it.
Tisha Guerrero contributed to this article.
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