The cash vs. ETF arbitrage

The creation & redemption process allows a trader (an authorized participant) to obtain or get rid of ETFs easily and at virtually no cost. From the composition, they can calculate the value of the ETF at any time with great accuracy.

The arbitrageurs – the traders monitoring the ETF prices and take advantage of price discrepancies – are comparing that theoretical value to the traded levels. If the price of the ETF deviates, their computers are jumping very quickly at the mispricing opportunity. Let’s see this on an example.

Arbitrage example

ETF vs cash arbitrage

The graph is a bit complicated at first sight. Here are some explanations:

  • In green is the ETF. It has three lines, the bid, the ask, and the last traded price. The last oscillates between the bid and the ask.
  • In blue is the basket of shares
    • Each of the stock component of the basket has a bid and an ask, so we can recalculate a bid and ask for the entire basket.
    • Because the stocks are usually less liquid than the ETF, the spread on the basket is usually wider than the spread of the ETF.
    • The last traded prices for each of the stocks give you the last price of the basket. That’s the theoretical value of the ETF, called the iNAV (indicative NAV, or intraday NAV).
    • The iNAV is also calculated by an index provider, but this publisher publishes the value only every 15 seconds. So the dotted blue line, that “official” published iNAV is always late. It is frozen, before becoming true to the iNAV every 15 seconds.
  • The basket of shares and the ETF have their own supply and demand. They can go up and down independently. They tend to remain in synch, but sometimes they don’t. That’s when the arbitrage opportunity happens.
    • When the bid of the ETF is higher than the offer of the basket, the computers jump in. They immediately sell the ETF and buy the basket of shares.

That opportunity doesn’t last long, as many computers are chasing for this. Actually, computers start buying the basket and selling the ETF even before the ETF has gone outside the ‘free’ range.

PS: There is a similar arbitrage situation between the cash and the index’s futures (that’s called also the ‘cash-and-carry’ arbitrage, as you have to carry that position until the maturity of the futures), as well as between the ETF and the futures. Because ETFs and futures are usually very liquid instruments with narrow spreads, these two instruments are very much in line all the time.


Influence of the arbitrageurs

The consequence of these arbitrageurs permanently verifying the ETF prices, selling when the ETF is too high and buying when the ETF is too cheap, is that the ETF rarely deviates from the theoretical value of its basket of shares

This is not the case for ‘listed mutual funds’, those mutual funds whose units are listed, but which do not have a creation redemption process. Since the arbitrage cannot take place, these fund units often trade at a discount of 1, 2, 3 or maybe 5 -7%

Another benefit of the arbitrageurs’ presence comes from their permanent hidden surveillance and their eventual interventions. If you look at the order book, you may see only a few thousand shares on the bid or the offer of an ETFs. That meager market depth is fallacious. If you start trading and you move the ETF away from its theoretical value, arbitrageurs will jump in and bring it back to its correct value. That means that new offers will suddenly appear out of nowhere, exactly when you need them. That magic liquidity appearing at a moment’s notice is  called the hidden liquidity. It’s a nice feature of ETFs.

This being said, if you need a real chunk of a given ETF, you are better off picking up the phone and calling one of the market-makers directly for a quote. 

Where the potential problems lay

The ‘official value’ of a fund and its units at the end of the day is called the NAV (Net Asset Value). It is calculated by the custodian of the fund and its accountants.

As we have seen, the fund manager of an ETF calculates and distributes an estimate of that fund’s NAV, based on the current market levels. That ‘real-time’ NAV estimate is called the “iNAV” where “i” stands for “intraday” or “indicative”. 

That iNAV is published on Reuters and Bloomberg, but it is not the ETF  price, since stocks trade on their own. It is an indication of where the NAV should be, if we were using the value of the fund’s constituents. The ETFs can move away from the iNAV due to offer and demand – before the arbitrageurs jump in.

Problem: the fund delegates this calculation to professional index calculators (S&P, Dow Jones…). Unfortunately, these index calculators are not always very precise:

  1. They calculate the iNAV only every 15 seconds at best, sometimes every minute. The market can be much faster than that.
  2. When the market is fast or there is a rare event, those calculators are not always accurate at all. This is what happened during Volmageddon on February 5th, 2018:
  • That day, the Fed announced that it would raise rates, a very scary thing for the markets. The S&P lost 4% and the VIX almost doubled on the close
  • The VIX leveraged ETFs and notably, the inverse leveraged ETFs are not based on the VIX itself (which is not tradeable) but on the price of the VIX futures. 
  • The way inverse ETFs work, if the VIX futures goes up by 1%, then the ETF goes down in value by 1%. If the VIX goes up by 10%, then the ETF goes down by 10% in value. And if the VIX goes up by 100% (doubles), then the inverse leveraged ETF should go down to zero. 
  • So on that day, where the VIX futures almost doubled (went up 95%), the VIX inverse leveraged ETF lost 95% of its value.
  • Unfortunately, for some yet unexplained reasons, the index calculator ‘forgot’ to calculate or publish the price of the iNAV for over an hour
  • Meanwhile, ETF continued to trade in the OTC market, and many people didn’t know that the iNAV published by Bloomberg was wrong.
  • And then suddenly, the index calculator turned its computer back on, and the iNAV instantly dropped from $80 to $5
  • A lot of pain that day, for many people. Many lawsuits have followed. They are still ongoing. 

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