Exchange-Traded Fund Best Practices: The Intraday Indicative Value Index

The underlying basket of securities held by an exchange-traded fund is worth no more or less than the sum of its parts. This is called the net asset value, or the NAV.

How prices are determined

ETFs' market prices are determined throughout the day through bid prices and ask prices posted on exchanges, just like stocks. However, there is another way to determine what an ETF is worth at any given point. This can be found by looking at the intraday indicative value (IIV) index, which shows what the NAV of the underlying holdings is worth at any given time.

How arbitragers benefit here

Differences between ETF market prices and the NAV of the ETF create arbitrage opportunities for market makers. If the ETF price is trading for less than the NAV, market makers will step in to buy shares of the ETF and sell the basket constituents. The reverse will happen in the case of a premium of the underlying. This arbitrage process helps keep ETF prices very close to their NAV.

Authorized participants (APs) will also step in to keep prices in check, through the creation/redemption process with the ETF issuer. The APs are the only parties that are allowed to transact directly with the ETF providers, and they control how many shares of the ETF will be available to investors.

It's not a perfect process

Arbitrage does not always work perfectly, and from time to time, market makers will not adequately trade away premiums and/or discounts. If an ETF maintains low trading volumes, sometimes premiums and discounts can persist. Thus, it is important for investors to compare the market price of an ETF to its NAV to ensure good execution.