When I search for explanations of how index-tracking ETFs avoid tracking error, the following explanation is normally given: ETFs allow certain Authorized Participants to trade the underlying assets for shares of the fund. So, for example, if excess demand artificially inflates the price of the ETF, an AP has an arbitrage opportunity -- they can buy the underlying assets at a lower price than the fund shares they will receive in return. They can then sell the shares they receive at a profit. I see how this prevents an ETF's NAV/share from diverging from its share price, but that is distinct from tracking error. During a period of excess demand for an ETF its share price and NAV/share, despite tracking each other, would seemingly rise more quickly than the index it is supposed to track despite. The AP may put additional selling pressure on the ETF price by selling the share they receive thus counteracting the excess demand. But I would not expect that to be enough. So my first question is this:
A) Do index-tracking ETFs tend to outperform their indexes if there is excess demand for them and vice verse, or do APs exert enough pressure on the ETF price to prevent divergence from the index?
The NAV/share of an index-tracking ETF will also diverge from its share price as fees are deducted (according to the expense ratio) and the NAV is accordingly adjusted downward. Can an AP still buy up underlying assets and exchange them for fund shares at a profit, i.e does an arbitrage opportunity still exist? I would not expect an arbitrage opportunity to exist, because in this case the share price has not necessarily diverged from its index even though it has diverged from its NAV/share. So my second question is this:
B) Is there still an arbitrage opportunity for APs when an ETF's share price deviates from its NAV/share due to fees? If so, why? And, if so, does this mean there is always additional downward pressure on the price of an ETF due to its expense ratio?
