ETFs track an index so they generally trade at a price that is close to the net asset value of the underlying stocks in the index. However, the price of an ETF can be influenced by investor demand, which can cause a fund to trade at a premium or a discount to the NAV. Sometimes these market anomalies create a “riskless profit” otherwise known as an arbitrage situation.
The other day I looked at an ETF that I follow closely and I noticed that the fund was up over 20%, while the market was up only 3%. As the day went on the fund quickly came back in line with the rest of the market. How does this work? The arbitragers in this case are large brokers or specialists called “authorized participants” who are able to interact directly with the ETFs in a way that other investors cannot.
Authorized participants have the ability to assemble a large portfolio of stocks that represent the underlying shares that make up the fund then exchange those shares for the ETF shares. The reverse of this situation is also an option for these market participants. Authorized participants act accordingly depending on whether the shares are trading at a premium or a discount.
So next time you miss that early morning rally you may want to check out a few index funds, you never know you may be able to get a discounted price.
