Most of what I’m saying was already said in the source or by others but let me add with the authorized participant (AP). An AP is a market maker or any other large financial institution with a lot of buying power. Let’s disregard the initialization of the ETF and look at when it’s already trading:
- the ETF is at nav
- the ETF is discounted to nav
- the ETF has a premium to nav
If the ETF is at nav what you’re paying for your ETF is the same as if you would’ve bought the underlying in the same proportions that your ETF has. AP did his/her job!
But it can also happen that a lot of people buy or sell the ETF while the underlying assets aren’t bought/sold in the same proportions. A discount (ETF trades bellow nav) or premium (ETF trades above nav) can be bad for buyers/sellers of the ETF as the price they’re paying or receiving isn’t the true price of the underlying. Discount, for example, could be good for buyers but is bad for sellers, vice versa for the premium to nav.
This discount/premium to nav is bad for the integrity of the ETF, but luckily we have APs. When the AP sees a premium the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market (if the AP doesn’t hold any ETF shares they exchange the underlying for newly issued ETF shares which they then sell). This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit. The inverse happens with a discount (buying ETF and then redeeming it for the underlying which they sell). The process is nicely laid out in the infographic below.
The AP earns almost risk-free money through arbitrage and makes a more efficient market. (fun fact: that’s why ETF units always are nice round numbers)
Sources for further education: