AppliedMultiple choiceFree solution

What keeps a liquid equity ETF trading close to the value of its basket?

  1. AThe fund manager quotes a price based on net asset value
  2. BParticipants can create and redeem against the basket
  3. CExchange rules cap how far an ETF may trade from its value
  4. DThe fund holds cash to buy back shares when they trade cheaply
Show the answer and worked solution

Answer: B – Participants can create and redeem against the basket

The binding mechanism is economic, not administrative. Authorised participants can deliver the basket and receive ETF shares, or hand back shares and receive the basket, so any gap between the two wider than the cost of doing that is simply a trade. The premium is therefore bounded by transaction costs, creation fees and borrow, not by any rule or by the manager’s quoting. A closed-end fund lacks this mechanism, which is precisely why closed-end funds sustain persistent discounts and ETFs do not.

  • A. The exchange price is set by trading, not by the manager.
  • B. Correct. Any gap wider than the cost of doing that is a trade, so the premium is bounded by spreads, fees and borrow.
  • C. No such rule exists; the mechanism is economic rather than regulatory.
  • D. That is closer to how a closed-end fund does not work, which is why those trade at persistent discounts.

Takeaway: Creation and redemption is what bounds an ETF’s premium.

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What keeps a liquid equity ETF trading close to the value of its basket? · QuantMax