Market participants can take advantage of this divergence by buying the underpriced ETF and selling the overpriced one. A more important reason that the strategy is not completely hedged is that while the ETFs can go up more than 100%, they cannot go lower than 0. "Cluster-Based Statistical Arbitrage Strategy," Page 2. That’s when the arbitragers step in. In the meantime, market participants will continue to benefit from temporary spreads between share price and NAV. I've used various different periods, and for the most part, one ETF in each pair is down more than its counterpart is up. It is not completely hedged. "Understanding the Flash Crash," Page 2. Take a look at the following most liquid 3x ETF pairs, and their performance since November 19, 2008 (the first date on which it was possible to buy/short both simultaneously). Any underperformance of the ETFs relative to the underlying index is the short seller's profit. Accessed June 1, 2020. For example, there are several S&P 500 ETFs. Follow Hobbes Investment Research and get email alerts. For individual investors, leveraged ETFs are alluring because of the potential for higher returns. Leveraged Equities and all other leveraged asset classes are ranked based on their … When ETF A is selling at a premium (or discount), individuals can buy (or sell short) the underlying securities in the same proportions and sell short (or buy) the ETF. The perceived increase in volatility needs further research. Each of these ETFs should track the underlying index (the S&P 500) very closely, but at any given point, the intraday prices can diverge. These arbitrage opportunities, like the previous examples, close rapidly, so arbitrageurs need to recognize the inefficiency and act quickly. Mispricings happen in the short term, and these opportunities close within minutes, if not sooner. Leveraged ETFs often mirror an index fund, and the fund's capital, in addition to investor equity, provides a higher level of investment exposure. ETF arbitrage is not a long-term strategy. These trades provide liquidity in ETFs and transparency in price. Other risks include liquidity issues as well as difficulty in borrowing the shares. Uh oh. Investigating Liquidity Illusions in the Exchange Traded Fund Market." Accessed June 1, 2020. We also reference original research from other reputable publishers where appropriate. Journal of Finance. Stanford University. That is, sell short both the bull and bear ETFs for the same underlying index for the same dollar amount. Everything is in balance and so far so good. Still, they also subject ETFs to intraday mispricing, as the trading value can deviate, even slightly, from the underlying net asset value. At these times, price fluctuations between the ETF and its underlying assets cause mispricings. Page 91. It is also a brief examination of how the less risk averse among us might take advantage of this fact. An authorized participant is an organization that has the right to create and redeem shares of an exchange traded fund (ETF). This position is partially hedged. The NAV of the underlying portfolio is updated every 15 seconds during the trading day, so if an ETF is trading at a discount to NAV, a company can purchase shares of the ETF and then turn around and sell it at NAV and vice versa if it is trading at a premium. The arbitrage opportunity happens when demand for the ETF increases or decreases the market price, or when liquidity concerns cause investors to redeem or demand the creation of additional ETF shares. However, there may be the case where the ETF or index lag and could possibly trade at $81 or $161. What Is the MSCI All Country World Index (ACWI)? Sell short the leveraged ETFs in pairs. Safe Until They Aren’t? Investigating Liquidity Illusions in the Exchange Traded Fund Market. BGZ should fall 10%. In shorting these ETFs, one's potential losses are unlimited. If this seems too good to be true, you are right to be skeptical, for there are plenty of risks. New York University Stern School of Business. At this point, the AP will notice the ETF is overpriced or trading at a premium. So if the underlying equities move up, so should the ETF and the index n direct correlation. Premium to net asset value (NAV) presents when the value of an exchange-traded investment fund is at a premium to its daily reported accounting NAV. BlackRock. A 2014 study titled “Do ETFs Increase Volatility?” by Ben-David, Franzoni, and Moussawi, examined the impact of ETF arbitrage on the volatility of the underlying securities. If not, there is chaos. This is called pairs trading, and it can lead to an arbitrage opportunity when the price of one ETF is at a discount to another similar ETF.. This one is best left for the gamblers among us. Value, Long/Short Equity, long-term horizon, medium-term horizon. And while ETFs may be attractive, be sure to conduct thorough research before making any trades. Accessed June 1, 2020. However, liquidity may be a limiting factor, impacting the ability to engage in this arbitrage. I am not going to try this out myself. Occasionally, over the very short term (i.e., intra day), both ETFs in a pair were up. ERY is down around 10%, while ERX is down over 50%. However, questions related to whether ETF arbitrage increases market volatility have arisen. Page 24. It will then sell the ETF shares it received during creation and make a spread between the cost of the assets it bought for the ETF issuer and the selling price from the ETF shares. University of Pennsylvania Wharton School of Business. Since November 19, TNA is down around 50%. Let’s say that the equities drop $5 each and now trade at $20. Traders, especially high-frequency traders, can take advantage of mispricings in the market, even if these inefficiencies last for just a few minutes or seconds. The AP’s job is to buy securities in equivalent proportions to mimic the index the ETF firm is trying to mimic, and give those securities to the ETF firm. "ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?" I am too scared of short selling (perhaps irrationally so) and like to replicate short strategies with puts. It often happens that one ETF rises more than its counterpart falls, and vice versa. Mispricing can occur between two similar securities, like two S&P 500 ETFs, or within a single security, where the trading value differs from the net asset value (NAV). Accessed June 1, 2020. Leveraged ETFs are portrayed in the media as tools of Satan to separate investors from their savings. As a simple example, let’s use an ETF that is made up of four equities. A redemption mechanism is a method used by market makers of exchange-traded funds (ETFs) to reconcile net asset value (NAV) and market values. It's a normal reaction to those who have read mainstream media warnings on leverage. However, once you are comfortable with ETFs, then it’s only matter of calling your broker (unless you trade online). ETF arbitrage is not a long-term strategy. But more important, arbitrage trades play an important role in the world of ETFs. This process is done at the net asset value of the securities, not the market value of the ETF, so there is no mispricing. These include white papers, government data, original reporting, and interviews with industry experts. Check the history of the ETF, understand the risks, watch the fund in action and see how it reacts to different market conditions. Accessed June 1, 2020. Exchange-traded funds, or ETFs, are one such asset that can be arbitraged. ETFs are securities that track an index, commodity, bond, or basket of assets like an index fund, similar to mutual funds. This type of arbitrage tends to work best on ETFs with the same underlying index. Its counterpart BGU is down close to 50%. To report a factual error in this article.