ETFs have two prices at once: the stock market price, which moves every second in trading, and the net asset value (NAV), which is calculated once a day based on the actual assets in the fund. It is no coincidence that both values are almost always almost identical.
• Stock market price and NAV of an ETF can differ from each other
• Authorized Participants are the only market participants who can create or destroy ETF shares directly with the ETF issuer
• The creation-redemption mechanism uses price differences as an arbitrage incentive
NAV and stock market price
An ETF combines the properties of two different fund structures. Like an open-ended investment fund, it can issue or redeem new shares daily at the NAV, which represents the total value of all fund holdings divided by the shares outstanding. At the same time, it trades continuously on the stock exchange like a closed-end fund, where supply and demand create their own price, as the European Systemic Risk Board (ESRB) notes in a working paper by Pan and Zeng.
NAV is calculated once daily, typically at the close of trading, based on actual trading prices, dealer quotes and estimation methods. State Street Global Advisors describes this process as follows: The ETF issuer bundles the delivered securities into the fund structure and gives the Authorized Participant (AP) ETF shares back, which are then resold on the stock exchange. The stock market price, on the other hand, always reflects the current achievable price on the stock exchange, which can be above or below the NAV depending on the market situation.
What are Authorized Participants?
The term appears in fund prospectuses, but is abstract for most investors: Authorized Participants (APs) are specially approved, self-processing broker-dealer institutions that are the only market participants permitted to trade directly with the ETF issuer. According to the US Investment Company Institute (ICI), APs can create or redeem ETF shares in large blocks, called creation units, from the issuer. Corporate bond ETFs typically have between 25 and 35 APs, according to Pan and Zeng’s ESRB working paper, including houses such as Goldman Sachs, JPMorgan, Barclays or Morgan Stanley.
A key feature of this role is its voluntary nature. APs sign a participation agreement with the issuer but are not contractually obligated to do anything. As the ESRB paper notes: “APs are not legally required to engage in ETF arbitrage.” They trade when the arbitrage return exceeds the transaction costs and risks. This has direct consequences for behavior in times of stress.
Creation and Redemption
If the market price of an ETF is above the NAV, an AP buys the underlying securities on the market, delivers them as a basket to the issuer and receives back new ETF shares, which it sells on the exchange at the higher price. Optiver describes this process as in-kind creation: The creation unit typically includes between 10,000 and 100,000 ETF shares and is defined in advance as a fixed block size. The additional ETF offering through Creation pushes the stock market price back towards NAV.
In the opposite case, the AP buys ETF shares at a discount, returns them to the issuer in exchange for the underlying basket of securities and sells them at a profit. The sum of these redemptions removes ETF shares from the market and drives the stock market price back up. VettaFi aptly describes the economic core of the mechanism: Without creation and redemption, investors can only trade in the secondary market, where spreads widen and liquidity decreases. The arbitrage is therefore not a side effect, but the actual constructive function of the AP system.
In addition to the in-kind variant, there is also cash creation, in which the AP does not deliver securities but rather cash to the issuer, which then uses it to purchase the fund components itself. In terms of arbitrage efficiency, the in-kind variant is usually superior because it does not require any additional trading steps on the issuer side.
When the mechanism reaches its limits
For stock ETFs, arbitrage works almost seamlessly because the ETF and underlying trade on the same exchange platforms and prices are available in real time. A fundamental asymmetry arises with bond ETFs: the ETF trades on the stock exchange with transparent real-time prices, while the bonds it contains are traded in the bilateral OTC market, a decentralized dealer network without central price determination. This discrepancy is the primary source of friction for arbitrage in corporate bond ETFs, according to the ESRB paper by Pan and Zeng. The consequences are measurable. Pan and Zeng show that a one standard deviation increase in market volatility reduces the arbitrage activity of APs by around 10 percent, even when the ETF premium remains constant. The BIS working paper approach by Kruttli, Monin and Watugala models this relationship similarly: an AP buffer between the ETF and the bond market is the reason why an ETF discount arises and temporarily persists when the AP acts as an intermediary to protect its own risk capacity. The Journal of Finance paper on municipal bond ETFs also shows that when dealers withdraw their liquidity support for bonds in the ETF portfolio, arbitrage loses its drive because APs shy away from buying bonds for arbitrage.
There is also a structural problem caused by the dual role of the APs. The same institutions also act as market makers for corporate bonds. If their own bond holdings are already undesirably large during market phases of increased stress, they sometimes use creation and redemption transactions to clean up their holdings instead of correcting the ETF’s price. The ESRB paper describes this situation as distorted arbitrage. The transactions then follow the inventory logic of the APs, not the relative mispricing between ETF and NAV.
How big deviations can be
During quiet market phases, premiums and discounts for liquid equity ETFs are typically below one basis point. For bond ETFs, the spreads are already somewhat wider in the normal state. In its trading white paper, Invesco puts the typical NAV deviations for investment grade corporate bond ETFs in normal phases at a few basis points, but points out that these values can increase significantly in stressful phases. The Central Bank of Ireland, in a review of ETF trading mechanisms, notes that investors are often unaware of the difference between market makers and APs, and that in some cases only the former are subject to contractual trading obligations. The distinction is relevant for investors: A discount on a bond ETF does not necessarily mean that the market is incorrectly valuing the fund. It can also express that the manageable price of the ETF shows a reality that the slower calculated NAV does not yet reflect.
Structural classification
The creation-redemption mechanism is for ETFs what the direct redemption of shares is for conventional funds: a pressure valve that prevents the market price from permanently deviating from the intrinsic value. However, its efficiency depends on APs being willing and able to arbitrage. In liquid markets, this willingness is structurally secured. In illiquid underlying markets it becomes more fragile because transaction costs rise, price signals become more diffuse and the APs’ own inventory risk increases.
The ESRB working paper basically summarizes this issue: the mechanism works, but its capacity is not a constant. It depends on the liquidity of the underlying markets, the balance sheet capacity of the APs and the current risk appetite of the intermediaries. Anyone who understands this evaluates ETF price deviations better: not as an indicator of malfunctions, but as a reflection of the current arbitrage costs.
Paul Schütte, editorial team at finanzen.net
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