Why is it difficult for the stock price to follow theNAV of an active ETF?

What will be an ideal response?

As noted in previous problems, the arbitrage process conducted by authorized participants (APs) becomes more difficult for an actively managedETF. The reason is that the AP does not know what the underlying portfolio is because theportfolio is permitted to deviate from the benchmark index. Hence, there is greater risk thatthe ETF's share price will diverge from the ETF's NAV. The end results is that it can be quite difficult at time for the stock price to follow the NAV of an active ETF. While this can be the case, there are forces at work that enable the stock price to approximate the NAV. More details on this subject are supplied below.

The price of an ETF share on a stock exchange is swayed by the forces of supply and demand. While imbalances in supply and demand can trigger the price of an ETF share to stray from its NAV, large deviations tend to be short-term for many ETFs. Two chief features of an ETF's structure support trading of an ETF's shares at a price that approaches the ETF's NAV. They are portfolio transparency and the ability for APs to create or redeem ETF shares at NAV at the end of each trading day.

Transparency of an ETF's holdings through full disclosure of the portfolio or established relationships of the components of the ETF's portfolio with published indexesor other indicatorsenables investors to try to profit from incongruities between the ETF's share price and its underlying value during the trading day. When there are incongruities between an ETF's share price and the value of its underlying securities, trading can more closely bring into line the ETF's price and its underlying value. For example, if an ETF is trading at a discount to its underlying value, investors may buy shares and/or sell the underlying securities. This modification in demand for the ETF shares and the underlying securities should change their respective prices and shrink the gap between the ETF share price and its underlying value.

The ability of APs to create or redeem ETF shares at the end of the trading day also helps an ETF trade at market prices that approach the underlying market value of its portfolio. When a deviation between an ETF's market price and its NAV occurs, APs may buy or sell creation units to capture a profit. For example, when an ETF is trading at a premium, APs may find it profitable to sell short the ETF during the day while concurrently buying the underlying securities. APs then swap the creation basket of securities for ETF shares that they use to cover their short sales. These arbitrage actions by APs help maintain the market price of an ETF's shares close to its underlying value.