In recent weeks, an increasing number of financial professionals have taken to overhauling their knowledge of exchange-traded funds (ETFs) and their associated arbitrage strategiesWith the rapid expansion of the ETF market, concepts such as premium and discount arbitrage, futures arbitrage, and event-driven arbitrage have become focal points for many institutionsThe surge in popularity of ETFs has not only disrupted traditional actively managed funds but has also begun to influence passive investment vehicles like over-the-counter (OTC) index funds, leading some of them towards an ETF structureA significant number of OTC index funds are showing signs of transitioning to ETF-linked funds.

The transformation of index funds into ETF-linked funds raises many questions, especially considering that the underlying assets remain largely similarRecently, multiple index funds have disclosed their plans to reconfigure themselves as ETF-linked funds

For instance, on January 8, 2025, the Penghua CSI 500 Index Fund transitioned into the Penghua CSI 500 ETF Linked FundSimilarly, the Southern CSI 100 Index Fund announced its conversion to a corresponding ETF linked fund on December 27, 2024. Notably, the Huatai-PB CSI Star Chip Index Fund was converted into a linked ETF of its original structureFurthermore, on December 9, 2024, ICBC Credit Suisse's CSI 500 Index Fund made a similar move.

The CSI 500 Index Fund's metamorphosis into an ETF-linked fund represents a larger trend seen in the marketSince November 2024, several large asset managers, including E Fund, GF Fund, Huaxia Fund, Tianhong Fund, and others, have also transformed their respective CSI 500 index products into ETF-linked fundsIntriguingly, many of these products were established before their corresponding ETF products.

One explanation provided by industry experts for this transition is the dynamic nature of market demand

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By modifying index funds into ETF linked funds, asset managers enhance the potential for ETF growth and market liquidityFor instance, if the trading volume of the CSI 500 ETF on the exchange stands at 10 billion CNY, and the OTC redemption volume of the corresponding index fund matches this amount—assuming they operate independently—the growth of the ETF may be stymiedHowever, by converting index funds into ETF-linked funds, the hope is to consolidate volumes and see the ETF's size potentially double.

The operational aspect of converting an index fund into an ETF linked fund is relatively straightforwardGiven that index funds also follow a structure of holding a basket of stocks determined by index constituents, the conversion simply requires transferring holdings from the original index fund to the ETF structureThis facilitates a smoother transition and can help increase the scale of the ETF provided that the underlying stocks remain unchanged.

The ETF ecosystem operates on a principle of survival of the fittest

Within a landscape of index-mimicking ETFs, those with larger asset bases typically attract more investor attention, while those with smaller assets risk being liquidatedAs such, it has become a collective goal for participants in the industry to increase ETF sizes and move to the forefront of similar index-based products.

Arbitrage strategies, encompassing ETF transactions, have also seen a spike in interestRecent data reveals that the total market valuation of ETFs has surpassed 3.6 trillion CNY as of January 9, 2025. Increasingly, institutions are engaging in intensive study of ETF arbitrage trading, and various firms have produced educational materials centered on these strategies.

Industry veterans categorize ETF arbitrage strategies into three principal forms: premium and discount arbitrage, futures arbitrage, and event-driven arbitrage.

Premium and discount arbitrage concerns the divergence between an ETF's market price and its net asset value (NAV). Should an ETF be trading at a premium, an investor might purchase the assets stated within the ETF creation/redemption process and then redeem them for shares of the ETF, subsequently selling it at market price for a profit

Conversely, if the ETF trades below NAV, the investor can buy shares in the market and redeem them for the underlying assets, achieving a profit from the price discrepancy.

The existence of the premium/discount arbitrage mechanism serves to quickly stabilize ETF pricingMost professionals agree that as long as ETF redemptions remain unaffected, increased participation in premium/discount arbitrage should correct disparities between market and NAV pricesHowever, this method requires rapid trading and can incur risk if prices swing dramatically during the trading period.

Futures arbitrage, on the other hand, leverages price differences between futures contracts and their corresponding ETFWhen futures contracts are priced higher than the ETF, an investor might purchase the ETF while selling the futures contracts short, betting that the prices will convergeAt such times, selling the ETF and covering the futures position can yield profits

Oppositely, if futures are priced lower, investors can short the ETF while buying futures mutual funds to capture the price alignment later.

While this method can be profitable, it often necessitates the presence of corresponding futures products, factoring in trading costs and behavioral nuancesThis makes arbitrage viable only when significant price discrepancies exist.

Event-driven arbitrage comes into play in instances where an ETF's constituent stocks stop trading due to suspension or price volatilityInvestors may decide to purchase an ETF, anticipating substantial price movements once trading resumesIn such cases, they might redeem the ETF for various stocks, retaining the stagnant stocks while trading the others, waiting for favorable market adjustments.

However, industry insiders have pointed out the need for fund firms to safeguard investor interests by implementing cash substitutes during such arbitrage scenarios, effectively limiting opportunities tied to suspended stocks.

In conclusion, there is a burgeoning trend towards active ETF trading, supported not only by academic learning but also by dedicated investment products

Private equity firms are carving out ETF arbitrage products specificallyFor example, the "Xingyun Zhiheng (Xiamen) Private Fund Management Co." registered an ETF arbitrage-focused private securities investment fund in November 2024.

The financial landscape has evolved significantly since 2008, when the awareness around ETFs was minimalBack then, early adopters reaped generous rewards as the ETF space was still rich with untapped potentialToday, market players are realizing the concomitant opportunities ETFs present, extending beyond simple purchasing strategies to include systematic trading, broad asset allocation, and sophisticated trading methods.

As ETF trading grows increasingly popular, a variety of trading strategies—such as grid trading, T0 strategies, industry rotation, and enhancement techniques—are capturing the interest of financial institutionsTrade volumes also continue to soar, with more ETFs exceeding 100% turnover rates and daily transaction amounts crossing the 1 billion CNY mark.