ETF arbitrage is a trading method in which traders profit from a price difference between an ETF and its underlying assets or linked securities. As the arbitrage ceases, the value of the ETF shares converges with its NAV, resulting in an equilibrium price.
ETF Arbitrage takes the form of NAV Arbitrage and Pairs Trading, among other tactics. However, because the trading value might differ from the underlying net asset value, ETFs can experience mispricing, especially during intraday trade. This presents a chance for traders to benefit from ETF Arbitrage.
The arbitrage eventually levels the playing field and takes the ETF price to the same level as the underlying net asset value. Let us now take a closer look at the benefits and downfalls of ETF Arbitrage.
Pros & Cons of ETF Arbitrage
A market-moving arbitrage opportunity between ETFs has a significant impact. While it allows traders to profit from arbitrage, the approach does not come without inherent risks. Let us attempt to comprehend things in more depth.
ETF Arbitrage Benefits
Maintains Price Equilibrium:
The major benefit that ETF arb provides to the market is that it ensures long-term price equilibrium. Arbitrageurs take advantage of the ETF share price disparity, which finally converges with the NAV, removing any pricing inefficiencies.
Arbitrageurs Earn Lower-Risk Profits:
The ability to profit on asset mispricing in two markets is one of the most significant advantages of any arbitrage technique, and ETF Arb is no different. Traders that engage in ETF arbitrage earn money by reducing price swings to more efficient levels.
This phenomenon was described in 1980 by the Grossman and Stiglitz model, which said that “those who devote resources to gather knowledge do receive remuneration.”
ETF Arbitrage Risks-
Extra Costs Eats Into Returns:
Every investment carries risks such as the loss of principle, brokerage charges, and other additional expenditures that reduce returns. When APs desire to swap a securities basket for an ETF unit, they must pay a fee known as the Creation fee.
Stamp taxes exist in certain nations, such as the United Kingdom and Hong Kong, while sales taxes exist in others, such as South Korea and Taiwan. Additionally, there may be additional costs associated with owning ETFs for an extended length of time.
No Guarantee of Active Trading of ETFs:
We know that ETFs may be traded like stocks and that their prices can fluctuate a lot. There is no guarantee that an active ETF trading market will continue to exist or that the listing will stay unaltered indefinitely.
During a downturn, changes in market circumstances may also interrupt ETF trading or cause it to trade drastically below its fair value.
Propagates Liquidity Shocks Across Asset Classes:
ETFs, Arbitrage, and Contagion, a 2012 research study by Itzhak Ben-David, Francesco Franzoni, and Rabih Moussawi, shows that the underlying assets are vulnerable to intrinsic shocks. Simultaneously, as the ETF's ownership grows, the non-fundamental shock to the ETF markets grows as well.
As a result, the volatility of the underlying securities has increased. Arbitrage across ETFs, according to the study, might cause contagion risks across asset classes and undermine market stability in the long run.
The Bottom Line
ETF arbitrage has a unique set of advantages for both the market and the trader. As the ETF prices converge with its NAV over time, the ETF arbitrage mechanism assists the trader in locking in the spread profit.
However, because the ETF arbitrage mechanism highlights the asset's mispricing, it may enhance the volatility of the underlying assets.
As a result, arbitrageurs who use the approach wisely can profit from the transitory price difference between the share price and NAV.
So, even though ETFs appear enticing, make sure to do your homework before placing any transactions. Examine the ETF's past performance, as well as its underlying risk characteristics and performance in different market scenarios.
Written By – Devika Mishra
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