Index Arbitrage is a key aspect of ETFs, and a means by which ETF prices are kept in line with the price of their underlying baskets. Open-ended ETFs, unlike closed-ended mutual funds, allow certain large investors, known as Authorized Participants, to sell the fund the basket of underlying stocks in exchange for ETF shares. ETF share prices are kept in line with their underlying basket price via this mechanism, by which any differences between the two prices is arbitraged by Authorized Participants utilizing high frequency trading algorithms that spot and take advantage of even the most minute discrepancies.

Q. OK, we’re going to tie two recent conversations together with this one, right?
A. Yes. It’s a suggestion by our friend Peter Tchir, (but not because he doesn’t understand it!) An Index Arbitrage is accomplished through a high frequency trading program, but takes advantage of something we talked about last week regarding the plumbing of ETFs. The key thing to recall about ETFs is that the fund holds a static collection of securities inside it. The only time that set changes is when an Authorized Participant buys up a whole basket of all the securities the ETF holds and then gives the basket to the fund in exchange for new ETF shares.

Q. Right. So that’s different from mutual funds, which buy and sell the securities held by the fund every day in order to either redeem shareholders or issue shares to new investors.
A. Exactly. So last week we talked about how the Authorized Participants keep the prices of the ETFs in line with the underlying basket the ETF holds: when the price gets out of line, they can, for example, buy the basket of securities, turn them into the ETF for new ETF shares, and then sell those ETF shares into the market.

Q. OK, I see where this is going. The HFT guys can jump in front of that exchange.
A. Right. At times of high volatility, the prices of the ETF and the underlying basket of its stocks gets out of whack by small amounts pretty often. So here are the HFT guys, with their computers plugged directly into the exchange servers — remember, physically closer than anyone else’s computers, so they see this first– and their algos fire away, buying the basket and selling the ETF, or vice versa. Happens before the APs could possibly act. That’s an index arbitrage.

Q. So these sorts of things are driving a lot of volume, are they?
A. Yes, and you see how it becomes self fulfilling: the more volatility, the more arbitrage opportunities, the more volume. But right now you’re seeing a lot less volatility and a lot less volume, and lots of folks (including Peter) think that’s because, in the wake of the Knight trading fiasco, people have pulled their systems back for testing.

Q. That’s interesting. But does all this sort of HFT trading hurt individual investors?
A. This kind? Probably not. Its sort of a fair arbitrage play. But as you know there are lots of other HFT practices that do add to the prices normal investors pay– and they certainly add a ton of instability and risk to the system.