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Here is a quote from the Schwab document on how the arbitrage incentive works: “How is it that ETFs generally trade close to their [internal fair value or IFV]?It’s all about arbitrage—which drives APs to minimize the differences between an ETF’s market price and the IFV via the creation/ redemption process.For instance, ETFs that focus on higher dividend or dividend growth stocks design rules for screening or scoring stocks based on these attributes.

APs serve as the primary agents for creating and redeeming shares.

With respect to transparency, most open-ended mutual funds are actively managed, so investors have a basic idea of what they’re getting, but this can change depending on the active trading by the fund manager.

In contrast, many ETFs (those that file for passive exempted relief with the SEC) track an underlying benchmark, so the investors can be reasonably confident that an ETF will deliver the desired market exposure.

In addition, ETFs tend to exhibit lower turnover than actively-managed funds as turnover typically occurs with quarterly rebalancing and semi-annual reconstitutions; many ETF managers focus on tax efficiency as a goal so as to minimize the distribution capital gains due to rebalancing.

Much has been published on the underlying mechanics and advantages of ETFs.


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