If demand increases for an ETF above the available supply in the secondary market the Authorized Participant/Liquidity Provider (AP) will buy the basket of the securities underlying the index in the primary market. The AP delivers the shares to the ETF provider and receives in exchange newly created ETF units which are then sold to investors in the secondary market. The opposite takes place if selling exceeds demand from investors by the redeem mechanism. Every time an AP uses the create/redeem mechanism it earns an arbitrage profit. Competition between APs ensures tight bid/ask spreads, and the spread is often the best indicator of the liquidity of an ETF. The create/redeem mechanism ensures the price of an ETF is in line with its underlying net asset value (NAV). Creation and redemption of ETF shares takes place overnight with the ETF provider.
“Surprises” in recent ETF markets
As stated by one of the major ETF providers in one of their ETF descriptions, their ETF “aims to track the performance of the xxx index”, with no guarantee that the ETF will yield the same return as the underlying assets. This difference between the ETF and the underlying index is denoted the “tracking error”, and many investors are not aware that ETFs are not a direct 1:1 replicate of the returns in the underlying benchmark.In the volatile markets in March, where liquidity disappeared in many European ETFs, market makers spreads widened dramatically. As an example, the average bid-ask spread in percentage terms peaked during the month at 3.1% for an ETF tracking inflation-linked government bonds. The tracking error during this period increased significantly, and the ETF traded with a 4 % discount to the actual value of the underlying assets. In some cases with ETFs tracking corporate bonds the ETF price may go well below the fund’s net asset value because the underlying prices on the corporate bonds are uncertain or maybe rarely updated.