Apologies in advance for sprinkling in a little quantum physics1 during these crazy times, but if it can create a slight grin or even a slow shake of the head, it is probably worth it.
Almost any discussion on ETF trading is actually a discussion on relativity. When we talk about an ETF’s liquidity, we are really just measuring the impact of a trade in relation to its current market bid/ask spread. For ETFs, that bid/ask spread also has a relation to the value of all those underlying securities it holds.
For ETFs, that market you see also has a relation to the value of all those underlying securities.
ETF arbitrage is the term we use to talk about the relationship between the ETF price and the price of its underlying basket of securities. Typically when one price is higher/lower than the other, ETF liquidity providers will sell/buy the other, which helps keep the two in line.
During severe market moves, some observers question whether ETFs serve as mitigators or exacerbators of volatility. And back to quantum physics, it is impossible to observe the price action of underlying stocks independent of the price action of ETFs because of their relativity.
I have some more thoughts on this but will save them for a later day.
For now, I want to go back to ETF arbitrage. Typically those disconnects between an ETF’s price and its underlying basket price are very short-lived and very small in scale. However, very rarely—and usually during severe market moves and/or high levels of uncertainty in the values of the underlying securities—the duration of that disconnect can last longer.
Pricing that normally corrects itself in seconds may now take hours. ETF spreads will likely be wider, premium/discounts will be greater, and the trading will actually look more like single stocks or closed-end funds than open-ended ETFs.
So what are investors to do about this? Trading wise, in my view an investor should follow the types of good general trading practices I have mentioned since I first started blogging about my thoughts on ETFs: avoid market orders, avoid trading the market open (sadly, both the 9:30 AM EST open as well as post-halt open), use limit orders, and talk to your capital markets desk or your ETF liquidity provider.
Even in highly volatile or uncertain environments, the relation between an ETF and its basket is still there, even if the wobble between the two lasts longer than expected.
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1. Franklin Templeton cannot confirm or deny David’s understanding of quantum physics.