Arbitrage

• Bodie, Kane and Marcus in "Investments" define arbitrage as "a zero-risk, zero-net investment strategy that still generates profits." For instance, the price of a stock in one market may differ from the price of the same stock in another. In this case, an attentive investor can simply buy the stock in the market that offers the lower price, and immediately resell in the higher price market.
  
  

ETF Arbitrage

• The price of an ETF may differ from the market value of the securities that compose the ETF. This can happen, for instance, if an ETF receives a great deal of media attention while the securities that it holds do not garner media attention. This may cause a gap to develop between the price of an ETF and the market value of the securities it holds. This would create an arbitrage opportunity.
  
  

Examples

• If the price of an ETF is $100 per share and the market value of the securities this share comprises is $90, an investor can purchase the underlying securities for $90 and resell them to the ETF for $100. Alternatively, if the price of the ETF is $90 and the market value of the ETF's holdings is $100, then an investor can purchase the ETF, exchange it for the underlying securities and then resell the securities individually. In either case, the investor would net a $10 per share profit.
  
  

Considerations

• In practice, such large gaps between the price of an ETF and the value of its holdings rarely, if ever, exist. In most cases, the NAV of an ETF will be very close to its price. If gaps between the two develop, they are typically extremely small and temporary. This makes sense--if too large a gap develops, then investors will spot a profit opportunity, and as soon as they do, this profit opportunity will disappear. If the price of the ETF is less than the market value of the securities it comprises (or vice versa) then astute investors will bid up the price of the ETF (or the prices of the underlying securities) until the arbitrage opportunity no longer exists.
  
  

The Role of Arbitrage

• Arbitrage--or more accurately, the possibility of arbitrage--plays an important role in ensuring that the price of an ETF closely tracks the price of the basket of stocks the ETF tracks. The irony of arbitrage is that, in a perfect market, the possibility of arbitrage prevents actual arbitrage opportunities from ever arising. In other words, arbitrage is a potential though seldom exercised market force that ensures the price of an ETF will not stray far from the NAV of the securities it tracks.