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ETF Pricing and How To Trade On Price Inefficiencies

ETF market making is a major business at firms including Flow Traders, Optiver and Jane Street. This lesson is what that business actually involves.

The basic loop

Δ=PETF−iNAV\Delta = P_{\text{ETF}} - \text{iNAV}

If Δ>0\Delta > 0 the ETF is rich: buy the basket, create shares, sell them. If Δ<0\Delta < 0 it is cheap: buy shares, redeem for the basket, sell the basket.

Straightforward in principle, and the difficulty is entirely in the details.

What the gap has to cover

An apparent gap is not profit. Subtract:

Trading costs on the basket. Possibly hundreds of instruments, each with its own spread. This is usually the largest cost.

The ETF spread, on the other leg.

Creation and redemption fees charged by the issuer.

Financing for the period the position is held.

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