By Phil Mackintosh
ETFs Rarely Enter the Arb Zone
CONTENTS
Intraday trading of ETFs is very
competitive and efficient
90% of ETFs trade inside the
basket spread
Where is the “arb zone” & when
are ETFs truly rich or cheap?
Which ETFs trade rich and cheap
the most?
How can I avoid paying too much
for an ETF?
Crib Sheet:
ETF commentators talk a lot about NAV, representing the latest
calculation of an ETF’s underlying value. However market makers
can’t profit from deviations from NAV. They only make money when
and ETF is trading above the baskets offer or below the baskets bid.
Anything in between is effectively a “no arbitrage zone”.
We looked at how often ETFs really trade rich or cheap to their
basket, over the course of a day. The results might surprise you:
o 90% of ETFs traded inside the “no-arbitrage zone”.
o The maximum profit available to an arbitrageur was less than
$5,000, unlikely enough to cover all the trading, settlement and
creation costs!
Exhibit 1: Over a most of the day less than 10% of US domestic ETFs traded in
the “arbitrage zone” – outside the spread of the underlying basket.
Source: KCG Data, Aug 19, 2014 (Universe: Equity ETFs with US stock underlying ~ 450
members)
All this means that ETF market makers need to have very low trading
costs, and low latency, to compete against margins this tight.
Ultimately ETF investors benefit – in the form of very cost efficient
ETF trading, usually buying and selling cheaper than the spread on
the underlying stocks.
 ETF Trading Commentary Thursday, October 16, 2014

Intraday ETF Trading is Very Efficient

In our recent report on underlying ETF liquidity we highlighted
that most ETFs trade with tighter spreads than their underlying
baskets.
Exhibit 2: There are a number of ETFs with spreads wider than
Most ETF trading happens inside the spread their underlying stock basket – but the value they trade is small
(circle size).
Exhibit 2 compares ETF spreads to the underlying basket
spread. Circle size represents trading value – so it’s clear
that most ETF trading happens at spreads tighter than the
basket (below the diagonal).

Although this highlights the competitiveness of the ETF

market – it says little about whether ETFs are rich or cheap
at the time.

Most ETFs are trading at “fair” prices too

An easy way to see if an ETF is “fairly” priced is to compare
the trading prices to NAV. However that only works well
when the underlying stocks are trading at the same time as
the ETF (so the calculations of NAV and the ETF price are in
sync).
Source: KCG, Bloomberg (Aug 2014)
Universe around 650 ETFs. Includes ETFs with a live market hedge during US
In reality, even NAV is stale, representing an old “last price,
trading hours (Mostly US underlying ETFs). Excludes most international stock
often delayed as much as 15 seconds. A better, although baskets and swap backed ETFs.
more complicated, way to see if an ETF is priced correctly
is to look at the underlying bid and offer NAV (see sidebar Exhibit 3: Few ETFs traded more than 5bps rich or cheap at any
below). This will show whether arbitrage opportunities time in the day (circle size shows value traded, color is the
exist, a truer reflection of mis-pricing in the ETFs. multiples of the ETF spread that the mispricing represents).

1
We did this for over 450 ETFs with live basket prices for
the day of Aug 19, 2014. What we found was that:

o 42% of the ETFs never traded in the arbitrage zones,

and those ETFs accounted for 65% of value traded
o Most of the day, less than 10% of ETFs were mispriced
o The median worst mispricing (for the whole day), for
each ETF that did trade outside the basket spread, was
3.5bps (see exhibit 3).
o Very few ETFs trade more than 1 spread above (or
below) the arb zone, indicating that mispricings are
traded against relatively competitively
o The total profit for all arbs simultaneously at any point
in the day was less than $5000

Source: KCG, Bloomberg (19 Aug 2014)

1
Universe around 450 ETFs. US ETFs with US Underlying, excluding some ETFs
which are more complex to hedge or price – including those that are levered,
with covered calls or optionality and most bond ETFs.
 ETF Trading Commentary Thursday, October 16, 2014

How did we calculate the “Arb Zone”?

Arbitrageurs and market makers who try to trade at “last” might be lucky to get 50% of their basket done. The un-filled
stocks would be resting in the market on the wrong (near) side of the spread – or worse. That’s a bad way to arbitrage, as it
introduces a lot of unnecessary risk to their hedging strategy.

Market makers need a special kind of NAV

Instead, a market maker wants to complete their hedge and lock in the gains from the arbitrage opportunity instantaneously.
So they are more likely to lift all offers (for a stock-basket buy) or hit all stock bids (for a stock-basket sell). That way they
don’t need to manage partial fills and stock risk.

Most ETFs trade inside (between) the arb-zones

Consequently, arbitrage is actually only profitable when the ETF is richer than the basket offer (or cheaper than the basket
bid). We call this the “arb-zone” (in this report). We also refer to these two price levels as Offer-NAV (for the basket offer)
and Bid-NAV (for the basket bid). This is shown in Exhibit A1.

These price levels are not available to most investors – they’re also hard to calculate. But they are critical to KCG’s LMM and
Institutional ETF trading businesses. Consequently we continuously calculate them in-house for KCG Traders to use (without
the 15 second lag common for NAV). And that’s what we used for this report.

In reality, there are additional costs to trading an arbitrage basket which also need to be covered. Exhibit A1 includes these
trading costs via a ‘buffer zone’ over and above the baskets Bid or offer NAV. The size of the buffer zone is driven by a
number of factors including the cost of creations, the number of securities in the basket and settlement costs of those
securities, as well as the likelihood of multiple creations at once, to spread the fixed creation costs out.

Exhibit A1: NAV does not show where arbitrage can occur. ETF arbitrage is only profitable when the ETF trades richer (or
cheaper) than underlying stocks bid or offer + a margin for trading costs. This creates a large “no arbitrage zone” inside the
underlying spread – which is where most ETFs trade.

Source: KCG
 ETF Trading Commentary Thursday, October 16, 2014

What ETFs Trade Rich?

To help explain all that we have discussed above, lets look at some
real examples. Using the logic discussed above, we show how
specific ETFs traded during the day. In each of the charts below:

o The green circles represent the ETF prices

o The blue lines represent the Bid-NAV and Offer-NAV at each
point in time – so the zone between them is the “no arbitrage
zone”.

Note that ETF and Stock spreads both also contract over the day,
something we detail in our recent chartbook. This helps explain
why it’s harder to stay in the no-arb zone toward the end of the
day (see exhibit 1).
But for the purposes of these charts, ETF prices are measured in
underlying spread space. This makes the underlying spread look
fixed and prices looks static, even though they’re not.
If 90% of ETFs are trading in a non-arbitrage
zone, the amount of stock arbitrage should also
be relatively low.
It follows that ETFs usually impact stock trading
much less than people think.

Liquid ETFs trade efficiently, despite high volume and tight

underlying spreads
Let’s start with two of the most liquid ETFs in the US market: SPY
and QQQ.

Even though SPY trades over $20bn per day, most trades are in the
“no arbitrage-zone”. This is all the more impressive because the
underlying stocks have a spread of just 3bp.

The same is true for QQQ’s.

Exhibit 4: The most liquid ETFs don’t trade in the stock-arb zone very frequently – despite very high volumes and tight
underlying spreads

Source: KCG, Bloomberg (19 Aug 2014)

Small cap ETF quotes might have more volatility, but the
underlying basket is much wider too
Many traders feel like small cap ETFs move a lot when they trade
them. However small cap ETFs like IWM and VB also trade
consistently inside the spread. Part of the reason is that the
 ETF Trading Commentary Thursday, October 16, 2014

underlying spread is actually relatively wide (notice IWM in Exhibit

2 - Trading at 1bp wide, despite underlying spread around 20bps).

Consequently, despite the fact that IWM trading represents around

40% of daily small cap liquidity, we think the impact on small cap
stocks is much smaller than people expect.

Exhibit 5: Small cap ETFs have a wide basket spread that helps them stay inside the no-arb zone

Source: KCG, Bloomberg (19 Aug 2014)

Less liquid ETFs tend to misprice more easily, and might signal
underlying trades too
Typically it is the less liquid ETFs that are more likely to trade rich
or cheap. For example FPX and SCHB on the day in question.

Exhibit 6: Illiquid ETFs are more likely to mis-price. Trading like this could also signal underlying trade direction too.

Source: KCG, Bloomberg (19 Aug 2014)

How should this affect my trading strategy?

When an ETF is persistently rich (or cheap), the natural question is
to ask why? There is a good chance that one-sided natural flow is
having market impact on the ETF and signalling a trade to the
market.

In these instances there are benefits to trading in the underlying –

as we discuss in our recent report Baskets are Better.
 ETF Trading Commentary Thursday, October 16, 2014

This material is not research and is not intended as such. It has been produced by personnel employed within the Trading Strategy Department and/or
by Sales and Trading personnel of KCG Americas LLC (“KCGA”). This material is intended only for clients of KCG Holdings, Inc. and its subsidiaries
(collectively “KCG”). It is not intended for further dissemination in its present form or any other and may not be further disseminated beyond the initial
recipient without express consent from KCG. This material is not intended to constitute an offer, or solicitation of an offer, to purchase or sell any
security or financial instruments or to participate in any investment strategy. The securities and strategies referenced in this material are not intended as
recommendations and may not be suitable for you. KCGA believes that the information contained herein is accurate but does not warrant that is
accurate, complete or up to date. The views expressed herein are based on assumptions. Any of those assumptions may be incorrect. KCG does not
guarantee the performance or success of any opinion or idea expressed in the information. KCG assumes no liability to anyone as a result of the use of
this material. This material provides the observations and views of the persons who prepared the material. These observations and views may be
different from, or inconsistent with, the views of KCG or other Departments or persons within KCG. The observations and views expressed in this
material may change at any time without notice. KCGA makes markets and trades for its own account and may hold positions in any of the securities of
the issuers referred to herein or in related financial instruments. The persons who prepared this material may also advise our trading desks.

In the US, products and services are offered by KCGA, member FINRA/SIPC. In Europe, products and services are offered by KCG Europe Limited
(“KCGEL”) which is authorized and regulated by the FCA. KCGA and KCGEL are affiliates and are indirect subsidiaries of KCG. For additional
information about KCG (NYSE: Euronext: KCG) please visit www.kcg.com

© 2014 KCG Holdings, Inc. All rights reserved.