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If an ETF shareholder passively holds the shares, there is still active trading in the shares in the highly liquid basket by the AP's (to track the index), right? But doesn't this incur a cost to the passive shareholder? The AP's trade on risk free arbitrage, more so in volatile markets, does that trading incur a cost to passive ETF shareholders? Or does that cost (the other end to the risk free arbitrage is a cost to someone) only apply to the shareholders that trade the ETF shares (i.e. not passive)? Where do the costs of risk-free ETF arbitrage end up?

The following may seem somewhat biased but it is simply based on the fact that there is a risk free source of gain, so a rational agent would seek to exploit it:

The impression generally given is that only the next ETF shareholder pays a small "fee" to the previous shareholder they bought it from. However, I think this is not the case. I think it is an ongoing cost incurred on market prices (daily arbitraging), this is no free lunch, these costs are paid. And I think they eat away at (are transferred to) the general share value of all stocks, despite the apparent overall inflation, which is by and large central bank induced (as well as by mandatory pension inflows). I think this is significant.

Consider an AP and maximise these risk free profits: Imagine you have a market where there is one company and its bank, and the bank is also the AP. The company's stock goes in an ETF and there is one passive shareholder. The AP can do whatever. What would the AP do?

While it is known that there is information between AP's knowledge of next day data and today's trading for example, this question is about when and where the costs are or could be incurred.

  • Do you have some theoretical (unattainable) ideal in mind to measure the costs against? For example we might talk about the costs of trading in general against the mid value even though nobody actually trades at the mid. – GS - Apologise to Monica May 7 at 14:47
  • The impression generally given is that only the next ETF shareholder pays a small "fee" to the previous shareholder they bought it from. However, I think this is not the case. I think it is an ongoing cost incurred on market prices (daily arbitraging), this is no free lunch, these costs are paid. And I think they eat away at the general share value of all stocks, despite the apparent overall inflation, which is by and large central bank induced. I think this is significant. – Julius Baer May 8 at 15:54
  • I think you could make that argument clearer in your question or answer then. It wasn't at all obvious to me initially. – GS - Apologise to Monica May 8 at 16:06
  • Yes, I am trying to get more help or info from answerers and someone said, it is a one time cost during transaction, so then I can make it clearer. I asked him to consider to be an AP and maximise these risk free profits: Imagine you have a market where there is one company and its bank, and the bank is also the AP. The company's stock goes in an ETF and there is one passive shareholder. The AP can do whatever. What would the AP do? – Julius Baer May 9 at 10:43
  • You can edit the question to add that clarification. – GS - Apologise to Monica May 9 at 10:55
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One man's gain is another man's loss. ETF's are not as passive as they appear to be. According to one older estimate, 73% of secondary market trading consists of filling the high frequency risk-free ETF arbitrage opportunities based on the premium-discount spread between the funds benchmark and their NAV (portfolio). The question is where these costs end up, are they really balanced by discount v. premium? Are they really externalised for a passive ETF shareholder?

The cost to the ETF is initially captured by the tracking error but consequently, shock propagation causes liquidity reduction and hence volatility in the market. Volatility could in turn increase the tracking error and accompanying cost to the passive shareholder. The flash crash of 2015 was caused by this phenomenon and USO is now famous for it.

The tracking error allows authorised participants to trade on a risk free arbitrage opportunity.

Here is a tool from Direxion. It doesn't show that ETF's generally have a premium or discount but the two are never balanced. I would expect these statistics to be similar for other issuers. Looking at the imbalance over time, it may typically look like this (Performance tab), with the ETF's tracking error increasing over time. These risks are for example summarised here.

The profit of the risk free trading draws leveraging interest. The arbitrage opportunity is generally very small so the question to high frequency traders is how to leverage it. Moreover, links between ETF sponsors or affiliated entities and market makers exist and are allowed.

There are also apparently very few active authorized participants according to Blackrock: only 2 or 3 for smaller ETF's and only 7 or 8 for bigger ones.

The profits end up on banks' profit and loss statements under the Trading income post. The costs are externalised to ETF shareholders, central banks (that need to add liquidity to markets) and possibly to other traders. Companies are generally not directly affected by their share price in the secondary market. For them the main cost of a lower share price is an inability to perform acquisitions paid for with shares. Companies also do share buybacks, sometimes by increasing leverage (borrowing at low rates) and further externalising costs ultimately to central banks and thirdly the share price does feed back into for example a company's credit rating.

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  • This answer is not entirely correct. Some items are correct but some miss nuance or only the gist is correct. I will improve it later, when I know more. – Julius Baer May 6 at 9:17
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The ETF has to be trading at some premium to net asset value to make creation arbitrage worthwhile (or discount in order for the redemption risk-free arbitrage to happen). Due to the design of ETFs this effect is small but it does result in slight tracking error which will result in some small loss to the ETF investor at the time they trade.

For a passive investor, this cost, like buy-vs-ask spread, should be quite insignificant. For an active trader, still very small but probably worth calculating to fully understand it. High-frequency traders definitely would do well to account for it.

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  • I think your answer doesn't go very deep, but let me ask you this, if you were a lightly regulated HF trader, how would you increase your risk free profits? – Julius Baer May 6 at 17:45
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If the price of the ETF is higher than the NAV, the AP can buy the component shares, swap them for ETF shares, and then sell the ETF shares, capturing the spread. There is no cost passed on to the ETF shareholder.

The same process occurs if the ETF trades at a discount.

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    Who foots the bill, Bob? – Julius Baer May 5 at 10:19
  • The difference between the ETF's price and the NAV offers a risk free profit (less transaction costs). It's an arbitrage. – Bob Baerker May 5 at 12:06
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    To be super clear, the people who foot the bill are those who are over or under bidding on the ETF at the time and allowing an AP to arbitrage them. They directly lose. – Philip May 12 at 11:25

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