ETF (Mis)pricing

Abstract

Authorised Participants (APs), primarily market makers, possess the right to create and redeem Exchange Traded Funds (ETF) shares based on market demand. The important role they play in facilitating liquidity provision and eliminating ETF mispricing makes their behaviour crucial to the well-functioning of the ETF market. Using a novel regulatory dataset that covers the primary and secondary market transactions of 128 ETFs from 2018 to 2022, we identify a connection between mispricing (the difference between ETF prices and the Net Asset Value (NAV) of their underlying baskets) and AP's inventory. We found that the skill of specialized traders (APs) in managing inventory and the overall demand for an ETF are important reasons why its price might temporarily be "wrong." Our model predicted this, and our real-world data backs it up, showing these factors add explanatory power on top of standard economic or fundamental influences. Further, our model is helpful for understanding the incentive structure of APs’ market makingand arbitraging, as well as the mechanisms behind the significant mispricing observed in March 2020 across various ETF classes.