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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?

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    Why would ’excess demand inflate the price’?? The index fund can always buy more shares of all of the pieces of it, and if those go up because of demand, the index goes up. I don’t understand why an index fund would ever have that issue. – Aganju Oct 22 '17 at 20:20
  • Are you saying Authorized Participants exert an upward pressure on the index by transmitting the demand for the index fund through to its underlying assets? That may be partially true, but I doubt the prices of the underlying assets are so easily affected. If they were, wouldn't the APs lose their arbitrage opportunity? – partyphysics Oct 22 '17 at 21:06
  • @dave_thompson_085 Thanks for linking me to this. Ganesh's answer does a good job of addressing my question A. But I am still wondering about question B. Can APs make a profit when an ETF price hasn't diverged from its index as happens when fees are deduted? If not, then they must lose money correcting for the expense ratio. – partyphysics Oct 29 '17 at 18:09
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Normal index funds don't have such pressure. The NAV is arrived at every day based on asset value. The redemption and purchase are managed. The excess is invested or some assets sold.

An index based ETF can diverge from underlying asset. This is where AP either sell excess ETF or buy ETF to maintain the price with in the tolerance

  • Ah thanks, I guess I was specifically thinking of index based ETFs. I will edit my question to reflect that – partyphysics Oct 25 '17 at 15:10

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