What is the role played by an ETF's authorized participants?

What will be an ideal response?

The role play by as an authorized participant (AP) is to arbitrage any discrepancy between the ETF's NAV and the ETF's share price. Below we explain in detail this role.

For an actively managed ETF, the manager's objective is to create a bond portfolio thatmatches the performance of the benchmark index as closely as possible. To avoid the drawback of aclosed-end bond fund where the fund's market price differs from the NAV, an ETF employs a third party,called an authorized participant (AP), who is charged with the responsibilityof arbitraging any discrepancy between the ETF's NAV and the ETF's share price.

The arbitrage process that the APmust undertake is as follows. Consider thefollowing two scenarios:

Scenario 1: The ETF's share price exceeds the ETF's NAV.
Scenario 2: The ETF's share price is below that of the ETF's NAV.

In Scenario 1, the ETF's share price is expensive on a relative basis. The action taken byan as APwould be to buy the underlying ETF portfolio and sell the ETF's share. Theresult of the action of the APwould be the generation of a profitable arbitrage andthe result would be to reduce the ETF's share price until it comes close enough to the ETF'sNAV so that a profitable arbitrage is no longer possible.

In Scenario 2, the ETF's share price is cheap on a relative basis. The action taken bythe APwould be to sell the underlying ETF portfolio and buy the ETF's share. Asin Scenario 1, this action taken by the APwould be the generation of a profitablearbitrage. The result of this action in Scenario 2 would be to increase the ETF's share priceuntil it comes close enough to the ETF's NAV so that a profitable arbitrage is no longerpossible.

As can be seen, a third party (e.g., AP)plays a critical role in the process of keeping the ETF's price close to the ETF's NAV. The third party in this process is a group of large institutional investors selected by the ETF's sponsor to perform the function described. Because these institutional investors perform the arbitrage, they are referred to as arbitrageurs. Because they are retained by the ETF sponsor to take the action just described to bring about the equality of the ETF share price and the ETF's NAV by creating and redeeming ETF shares, they can be deemed as "authorized."

One anAP can create ETF shares by providing the ETF sponsor with a specified basket of securities in exchange for which the APreceives ETF shares, called Creation Units. These units can only be done in large, specified quantities of ETF shares. The action taken by the APin Scenario 1 results in Creation Units. When the APdelivers a specified number of ETF shares to the ETF sponsor in exchange for a specific basket of securities, the ETF shares exchanged are referred to as Redemption Units. In Scenario 2, the action by the APresults in Redemption Units.

The arbitrage process just described becomes more difficult for an actively managed ETF. The reason is that the APdoes not know what the underlying portfolio is because the portfolio is permitted to deviate from the benchmark index. Hence, there is greater risk that the ETF's share price will diverge from the ETF's NAV.

The difficulty and riskiness in the role played by APs can be seen in the financial crisis of 2008 where credit markets became highly illiquid. As a result, the ETF share creation/redemption mechanism for keeping the ETF's market price close to the ETF's NAV requiredAPs to transact in the ETF's portfolio of bonds. When credit spreads were extremely high in the high-yield bond market during this crisis, the creation/redemption trades were increasingly costly and risky for APs because they faced both high spreads and uncertainty about whether they could transact in the underlying portfolio of bonds. The end result was large tracking errors.