Can somebody provide a thoughtful response as to why it’s impossible for there to be an ETF bubble? I’ve tried to understand the nitty gritty of how ETFs actually operate (e.g., authorized participants etc.) and am curious whether there are circumstances under which ETF prices could materially diverge from the underlying asset(s) the ETF seeks to track.
Couple random thoughts:
Mutual funds take $$$ and purchase underlying securities so, taking fees aside, the fund performs along with the underlying securities it holds. There is a direct connection between the assets and performance of the mutual fund.
ETFs on the other hand are not purchasing additional assets of its underlying securities with additional $$$ from investors, but rather rebalancing its basket of securities in order to mimic whatever underlying security the ETF is tracking.
What’s to stop the ETF security itself, which from my understanding trades wholly separate than the assets the ETF is tracking, from diverging from the underlying assets it seeks to track?
Understanding this is a bit random/stream of conscious/possibly not even accurate, but am very curious to hear peoples’ thoughts on this topic.
Comment from iguessjustdont:
Let me know if I am misinterpreting your question.
Authorized persons make security for security transactions with the fund between ETF shares and the underlying securities. ETFs do not trade “cash for securities”, but they do increase their fund size proportionally to the underlying securities.
Suppose the purchase of an ETF on the market leads to the market price going above the NAV (capital inflows). The authorized persons purchase the underlying securities in a specific proportion and trade them to the fund for a creation unit, typically 50,000 or more shares of the ETF, which they then sell on the market, driving the market price closer to NAV and generating arbitrage for themselves. The same works in reverse with them buying ETF shares and exchanging them for the securities if NAV is worth more than market price. Supply and demand. The ETF trades its lowest cost basis securities out of the fund to the authorized person in these cases to mitigate or eliminate tax burden.
Some situations where this breaks down:
– If the ETF is thinly traded, like a lot of the new ETFs which have a low market cap, let’s say $10M. If the underlying securities are in an index which requires a $2M investment to purchase the authorized person may have to take a lot of risk in the arbitrage transaction, and may not act unless the ETF market price deviates significantly from NAV.
– If underlying securities are thinly traded it may be difficult for an authorized person to not significantly impact the market by running up price or increasing volatility. They may wait until the price deviation is greater to cover the risk, or do slower roll-outs. In this case the fund will typically use a representative security. This is most common in bond ETFs where indexes may include securities not readily available on the market. It leads to tracking error.
– Failure to properly rebalance during creation unit exchange with the fund, or rebalance in response to the underlying index or prospects rules can cause the NAV of the fund to deviate from the index.
There are more but I already wrote you a wall. PM me or respond if any of this was unclear or didn’t get at your question.