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E xchange-traded funds (ETFs) and other exchange-traded products (ETPs) provide simple and efficient diversification and exposure to a wide range of asset classes. The equity markets where ETF shares trade are usually much more investor-friendly than the underlying market structures for other asset classes. Low bid-ask spreads combined with generally low fund expenses have made ETFs an extremely popular investment product--now accounting for approximately 28% of the value of U.S. exchange trading, according to Credit Suisse.1
However, ETF transaction costs are not as low as they might seem. ETF prices can and do deviate from their Net Asset Values (NAVs), and an investor's true transaction cost is the amount of the deviation from the contemporaneous NAV. Narrow bid-ask spreads can be a very misleading indicator of the true cost of trading ETFs. This paper examines how and why ETF prices can deviate from the NAV, along with some of the implications for investors. Investors need to be aware of these potential deviations when they place their orders. Market-on-close (MOC) orders, for example, are often much more costly than they appear.
ETF SHARE CREATIONS AND REDEMPTIONS--THE ROLE OF ARBITRAGE FORCES
ETF trading prices are set by supply and demand in the marketplace; there is no regulatory requirement that they be tied in any direct way to the underlying NAVs. Investors rely upon an arbitrage mechanism to keep ETF prices in line with the underlying portfolio values. When the price of an ETF is below the underlying portfolio value, arbitrageurs step in to buy the cheap ETF. They then hedge their risk in buying ETF shares, usually by selling the basket of underlying securities or a correlated proxy portfolio or index. This arbitrage activity normally pushes the price of an ETF into alignment with its underlying securities. However, this arbitrage activity only takes place when the ETF price has deviated enough from the underlying portfolio value to make arbitrage worthwhile. ETF prices will fluctuate within a band determined by the cost of arbitrage and the balance of supply and demand for the ETF's shares among investors.
To unwind an ETF arbitrage position, an arbitrageur may reverse the original trade if the price discrepancy has reversed, or close out the position by creating or redeeming ETF shares...