ETF Primary-Market Arbitrage: Creation/Redemption Baskets and NAV Gaps

Key Takeaways

• ETF price and NAV disconnects are driven by differences in secondary-market liquidity and frictions in the primary creation and redemption process.
• Authorized participants, using creation units and in-kind baskets, are the central arbitrage engine that keeps ETF prices close to NAV under normal conditions.
• During market stress, trading costs, basket composition mismatches, and settlement or funding frictions can produce persistent premiums or discounts that are tradeable.
• Arbitrage opportunities require modeling execution costs, creation/redemption fees, basket slippage, and counterparty constraints, not just the headline NAV gap.
• You can structure strategies to capture dislocations, but you must quantify liquidity, capital, and operational risk explicitly before trading.
• Know the ETF structure, creation mechanics, and who the APs are, because the same nominal NAV gap can have very different arbitrage economics across ETFs.

Introduction

ETF primary-market arbitrage is the mechanism that normally pins an ETFs market price to its net asset value, NAV. It relies on authorized participants creating or redeeming large blocks, called creation units, by exchanging baskets of underlying securities for ETF shares and vice versa.

Why should you care? If you trade ETFs, you need to understand when that mechanism works and when it breaks. Do you know why some bond ETFs can trade several percent away from NAV during crises while mega-cap equity ETFs stay tight to their NAV? What are the true costs of arbitrage when markets get chaotic? These are the questions this article answers.

In the sections that follow you will get a clear primer on the primary-market process, the anatomy of NAV premiums and discounts, the frictions that create tradeable dislocations under stress, and practical execution considerations for capturing or avoiding those moves.

How the ETF Primary Market Works

The primary market is where ETF shares are created and redeemed, and it is distinct from the secondary market where most investors buy and sell ETF shares on exchanges. Creation and redemption happen in blocks, typically 25,000 to 500,000 shares, called creation units.

Authorized participants, or APs, are broker-dealers or market makers that have contracts with the ETF sponsor to exchange creation units for a specified basket of securities. For most U.S. equity ETFs the exchange is in kind, meaning the AP delivers the underlying stock basket to receive ETF shares, or delivers ETF shares to receive the underlying basket.

In-kind vs cash creations

In-kind creations reduce taxable events because the sponsor transfers securities rather than selling them. Cash creations are more common for certain asset classes like fixed income, commodities, or non-US baskets where delivering a full in-kind basket is impractical.

The ETF sponsor publishes a daily creation/redemption basket or a list of acceptable instruments. APs use that list to construct the basket efficiently, often trading across multiple venues to assemble components before creating or after redeeming.

How NAV Premiums and Discounts Form

ETF market price is the last traded price on the exchange, while NAV is the per-share value of the underlying holdings. Ideally these track closely thanks to AP arbitrage. But several forces cause spreads to appear.

At the simplest level, an ETF trades at a premium when secondary-market buyers pay more than the NAV, and at a discount when sellers receive less. But that observation begs the question, why do buyers or sellers accept a deviation if APs can arbitrage it away?

Sources of NAV gaps

• Underlying market liquidity mismatch, where ETF liquidity exceeds underlying liquidity, or vice versa.
• Execution and transaction costs, including bid-ask spreads and market impact for assembling or disposing of the creation basket.
• Timing and settlement differences, such as a stale NAV for less liquid assets, or delays in pricing for nontransparent holdings.
• Regulatory and operational constraints, including capital limits, account restrictions, and ETF-specific rules about foreign securities or basket substitutions.

Under normal conditions those costs are small relative to the arbitrage window. APs step in, buy the cheaper instrument, and create or redeem to lock in the spread. That flow compresses the market price back toward NAV.

Creation/Redemption Frictions That Create Tradeable Dislocations

When markets stress, the small frictions that are usually ignored become economically meaningful. Costs that are normally a few basis points can balloon to multiples of NAV gaps. Those amplified frictions allow persistent premiums or discounts to form.

Think of the primary market like a gearbox. When its well-lubricated, arbitrage is fast and cheap. When lubrication disappears you get grinding and delays. What specifically grinds the gearbox?

Key frictions

1. Liquidity and market impact: thin bond markets or illiquid small-cap stocks mean APs pay high market impact to assemble the basket. That can make arbitrage unprofitable even when the headline gap looks attractive.
2. Basket composition and substitution: ETFs that track complex indices may accept substitutions or hold derivatives. When the published creation basket does not match what APs can easily source, slippage increases.
3. Cash vs in-kind creation costs: cash creations require the sponsor to buy underlying securities, which can be slow or expensive in stressed markets. That cost is passed to the AP and reduces arbitrage incentive.
4. Settlement, capital, and funding constraints: APs face margin, capital, and funding limits. In crises, these limits bite and APs may refuse to create or redeem, or they charge wide spreads to compensate.
5. Indicative NAV (iNAV) limitations: iNAV updates intraday but may be stale for ETFs holding less frequently priced assets, causing market participants to misprice and APs to hesitate to transact on stale information.

When several of these frictions occur together you can get wide and persistent dislocations. For example, in March 2020 many corporate bond ETFs experienced discounts of several percentage points relative to their estimated NAV as secondary liquidity dried up and APs were reluctant to create or redeem against illiquid bond baskets.

Arbitrage Mechanics and Execution Considerations

Arbitrage is not just identifying a spread. You must compute the full round-trip costs and the operational feasibility before taking positions. This is where experienced traders make or lose money.

Step-by-step arbitrage economics

1. Measure the raw NAV gap, Market Price minus NAV, expressed as basis points or percent.
2. Estimate transaction costs to acquire or liquidate the underlying basket, including bid-ask spread, market impact, and commissions.
3. Include creation/redemption fees charged by the ETF sponsor. These can be fixed amounts per creation unit or embedded in the creation-in-kind process.
4. Factor in carrying costs, such as financing rates, credit lines, and the expected time to execute/redemptions.
5. Model extreme tail scenarios, since stressed conditions can widen your execution window or prevent settlement, producing additional slippage or losses.

Only if the expected profit after those costs is positive and the operational path is reliable should you proceed. You must also ensure your broker or AP partner will execute the primary-market leg on demand.

Practical example

Suppose $XYZ ETF is trading 1.2% below NAV and the creation unit is 100,000 shares. An AP can buy ETF shares in the secondary market at $49.00 while NAV indicates $49.60. Creating a unit would deliver the basket valued at $49.60 to the AP when redeeming, netting a theoretical 0.6% profit after adjustment. But if assembling the basket costs 0.4% in market impact and the sponsor charges a 0.1% fee, the net profit disappears. Now add a funding spread and a potential one-day delay and the trade could be a loss.

Real-World Examples and Case Studies

Observing historical episodes helps make these dynamics concrete. The most instructive periods are stress events when liquidity evaporates and AP behavior changes.

March 2020 bond ETF dislocations

During the COVID liquidity shock, many corporate bond ETFs, including broad investment-grade and high-yield products, traded well away from NAV. APs faced severe challenges sourcing illiquid bonds, and market impact costs exceeded normal levels. Some ETFs traded at discounts of several percentage points for days until central bank liquidity programs restored market functioning.

Equity ETF resilience

By contrast, large-cap equity ETFs like $SPY historically remain within a few basis points of NAV under normal stress. The reason is deep, transparent underlying markets with narrow bid-ask spreads and plentiful AP capacity. That contrast illustrates why ETF structure and underlying liquidity matter more than headline NAV gaps.

Common Mistakes to Avoid

• Focusing only on headline NAV gaps. If you ignore transaction costs and basket assembly risk you will overstate the potential profit.
• Assuming APs will always act. In stressed markets APs may be capital constrained or unwilling to create or redeem at the published basket.
• Neglecting funding and settlement timing. Short windows can amplify costs, especially for cash creations where the sponsor must source securities.
• Confusing ETF liquidity with underlying liquidity. A tight market price for an ETF does not guarantee you can execute the reverse leg in the underlying cheaply.
• Underestimating tail risk. Liquidity can evaporate quickly, turning an expected profitable arbitrage into a loss overnight.

FAQ

Q: What is an authorized participant and why are they important?

A: An authorized participant, or AP, is a market maker or broker-dealer authorized by an ETF sponsor to create and redeem ETF shares in large blocks. APs are the primary arbitrage mechanism that aligns ETF market prices with NAV by exchanging ETF shares for underlying securities and vice versa.

Q: Why do bond ETFs show larger NAV gaps than equity ETFs?

A: Bond markets are often less liquid, with wider bid-ask spreads and larger market impact for trades. In stressed conditions those costs can make creation or redemption expensive, allowing ETFs to trade at persistent premiums or discounts compared with their NAV.

Q: How do cash creations affect arbitrage economics?

A: Cash creations require the ETF sponsor to buy the underlying securities on behalf of the AP, which can add execution risk, timing delays, and higher transaction costs compared with in-kind creations. Those additional costs reduce arbitrage profitability and can widen NAV gaps.

Q: Can retail traders profit from NAV dislocations?

A: Retail traders can profit indirectly by trading ETF pairs or using liquidity-aware strategies, but direct primary-market arbitrage typically requires institutional scale, AP relationships, and capital. Retail traders must carefully model execution costs and risks before attempting to exploit NAV gaps.

Bottom Line

ETF primary-market arbitrage keeps ETF prices disciplined under normal market conditions, but the mechanics are fragile. Creation and redemption baskets, AP capacity, and settlement mechanics all matter when you evaluate NAV premiums and discounts.

If you trade or design strategies around ETF dislocations, you must go beyond the headline gap and model execution costs, basket slippage, funding constraints, and counterparty behavior. At the end of the day, profitable arbitrage is as much about operational readiness and capital as it is about identifying a price discrepancy.

Your next steps should be to map the specific ETF structures you trade, quantify realistic transaction costs for the underlying holdings, and confirm access to counterparties who can execute primary-market actions. That discipline separates opportunistic trades from costly surprises.