On the other hand, if an ETF shows a discount to its iNAV, a market maker can reverse the process and redeem ETF shares for a basket of underlying stocks.
However, if the markets for the underlying assets are closed or illiquid, arbitrage on the last calculated indicative value becomes difficult and market makers may shift to a so-called Price Discovery Paradigm (PDP) where prices are determined by basic supply and demand forces, Haughton added.
For instance, price discovery is more likely applied to U.S.-listed international stock ETFs where the iNAV may be stale for many hours. Since foreign markets are typically closed during normal U.S. trading hours, a market maker would be unable to find up-to-date indicative values. Consequently, these international stock ETFs will follow normal price discovery and may trade at premiums or discounts to their NAV.
The Global Index Group also pointed out that ETFs have improved liquidity in normally illiquid areas of the market due to the price discovery mechanism. For instance, bid-ask spreads in high yield bond ETFs are tighter than those found in the underlying junk debt securities markets.
“The IVP is not applicable in every asset class or in every time frame. This means investors need to be alert to the trading paradigm of each security to make efficient use of the tool,” according to the Global Index Group. “Some investment tools are bringing additional liquidity to illiquid assets. This improvement in market efficiency helps market participants, but means that investors must adapt to using the PDP much as they do in trading individual securities. One cannot free ride on the Price Discovery in the underlying assets, since it is not happening.”