As far as I understand, the issuer of an ETF following S&P 500 should hold shares of the 500 companies included in that index. So, when company A goes out of the index and company B goes into it, the ETF issuer should sell all shares of A and buy shares of B instead.

Suppose an investor knows that such a change is going to happen. He can take advantage of this knowledge by bidding to buy many shares of A in a low price and to sell many shares of B in a high price. Since the ETF issuer is obliged by regulations to sell A and buy B, it might have to accept the investor's unfair prices.

Is this scenario possible, and if not, what is done to protect against it?

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    Welcome to Money.SE. I believe you have your supply/demand curve backwards. If ETF will be buying B shares, won't you want to buy just ahead of that? Dec 29 '14 at 17:59
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    Have you ever looked into the creation/redemption process for ETFs?
    – JB King
    Dec 29 '14 at 18:47

Everybody else also knows about the change in the index. It doesn't just impact ETFs but also all the index funds. Many funds will spread the transactions out. Many times there is a gap of weeks between the announcement and the change.

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    The implication of this being, unless you have insider information (which would be illegal to act upon), the bid/ask should already have adjusted for this very shortly after the news came out (within hours or less, often). You could speculate that it had not completed its adjustment, but that would be speculation.
    – Joe
    Dec 29 '14 at 20:54
  • @Joe "the bid/ask should already have adjusted for this very shortly after the news came out" - by whom exactly? I never thought that I can be quick enough to take advantage in the index change, but, if many people act instantly when the news come out, isn't there a chance that the first to act will make a large profit on the expense of others? Dec 30 '14 at 5:35
  • By normal market forces. When there are millions of people investing, enough of them will see the news shortly after it comes out that the bid/ask will adjust - particularly when many of them are professional traders. You can't reasonably be the first to act as an individual investor, and if you did suddenly buy up a huge amount of XYZA right after it were announced, the price would rise while you bought it and then likely fall back where it belongs - you're solely looking at this as a supply/demand problem, when stocks are only rarely priced as a result of such.
    – Joe
    Dec 30 '14 at 15:59
  • Think of it this way: Unless you could buy almost all of a particular stock, when you buy at (say) $10-$11-$12 and then offer to sell at $20 your shares, others holding stock will see the rise and think "Hmm, let's sell now while it's overpriced" and offer for sale at $11. You'd have to monopolize the stock in order to do this - which would be very hard or impossible to do cost-efficiently, particularly as others see what you are doing (and market rules might come into play as well).
    – Joe
    Dec 30 '14 at 16:01

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