The ETF Price Adjustment Process Explained In Detail

This guide is part of our Comprehensive Guide To ETFs. We strongly recommend checking out the guide in full to get a better understanding of ETFs.

The arbitrage process for ETFs is actually a little more complicated than described previously. To understand the process it is important to understand what it means for a fund to be open-ended.

Open-ended

ETFs are open-ended funds which means that units can be created (issued) or withdrawn (redeemed) from the market. There are special authorised market participants that can trade directly with the ETF issuer.

The authorised market participants can go to the ETF manager and swap a unit in the fund for a representative portion of the portfolio that the fund tracks and vice versa.

For example, for the fund STW, which tracks the ASX 200, an authorised participant can go into the market and buy a bundle of stocks which represent the composition of the ASX 200. The participant can then go to the STW manager and swap the bundle for a unit in the ETF.

Making money from swapping

Example: STW market price less than NAV

If the STW market price falls below the NAV an authorised market participant will:

  1. Buy units in STW
  2. Take the units to the STW issuer and swap them for the underlying securities
  3. Sell the underlying securities on the market for a profit

This process will continue until the market price of STW has been pushed up to equal the NAV, at that point the arbitrage opportunity will not exist anymore.

Authorised Market Participants: The Market Maker

Without getting too technical, the buy and sell process on exchanges involves a middle man called a ‘market maker’. The market maker will literally make the market for a security by matching buyers and sellers. The market maker can also buy and sell securities themselves. It is the market maker who often arbitrages differences between the price and the value of the ETF as they have the right to redeem units with the ETF issuer or have units created.[1]

Trading below or above the fund’s Net Asset Value (NAV)

“Some other listed managed funds may trade at a discount or premium to NAV.

This discount/premium can change over time. Consequently the value of an investment in one of these funds may fluctuate for reasons other than changes in the NAV.”[2]

 

Back to Comprehensive Guide To ETFs >>

Continue to Issuing And Redeeming ETF Units >>

 

References

[1] Introduction to ETFs, ASX, 2011

[2] Buying, holding and selling ETFs: Market Makers, ASX, 2011