ETFs by their very purpose, are meant to track their corresponding index whether that be the S&P, the Dow Jones or the Nikkei 200. Most ETFs will have tracking error, and like all stocks, will suffer from market inefficiencies from time to time. Tracking error, however, is not the same as market inefficiencies as its usually a ramification of expense ratios, leverage and FX volatility amongst other factors.

Still, one occurrence proves to cause inefficiencies time and time again. Namely, the dollar amount of an ETF, and its effect on the precision of mirroring a corresponding index. For example, the SPY[1] is worth $397.26 a share. This means that if SPY moves a cent, it would impose a change of 0.0025% (2sf). In contrast, the Nikko AM STI ETF[2] (BLMBRG: DBSSTI:SP) or (SGX: G3B), is worth S$3.18. If G3B moves a cent, it imposes a change of 0.31% (2sf). The STI[3] incites a change of approx. 0.032% and as such, often, meaningful enough inefficiencies open up; ones that investors could hypothetically exploit.

From the graph, it is blatantly obvious that G3B, cannot accurately track the STI, due to the constraints it has vis a vis its degree of precision. This opens up gaps of around +/- 0.1% to 0.2% between the two.

At first glance, this may appear a huge exploitable opportunity for the retail investor. After all, if you, bought or shorted stocks when a 0.1% gap opened up, ten times a day and then proceeded to sell or cover positions when the inefficiencies closed up, one could create a 1.1% (2sf) return daily. When compounded over 253 trading days, this makes the SPY’s return seem meaningless. Such investors would be wrong as many factors could make this a risky trading strategy best left to the quants.

Firstly, this strategy relies on the notion that outside volatility is non-existent when this is often not the case. Like most strategy, the Sharpe Ratio is far from 0. News ranging from Fed Policy to political upset in addition to currency fluctuations could bring great risk to positions, exposing you to just as much risk ordinary ETF investors would hold.

Trying a similar strategy on even XLF, the S&P Finance based ETF priced at $34.441 would bring returns trifling when compared to G3B, because of the difference in price. The same returns would be near non-existent when applied to SPY or QQQ. As such, adequate discernment is required to pick out an ETF that underlying assets are relatively stable and unaffected by external factors, yet not too stable that no volatility exists are opened up, traded in a large enough volume that the stock is liquid, and priced below $5.

Finally, investors must have access to high-speed real-time financial data. Most ‘real time’ data advertised by brokerages are not really. Rather, they have a lag of anywhere from a few seconds to 15 minutes. That is exactly why quantitative hedge funds spend a fortune trying to get as close as possible to exchanges, in an attempt to shorten this ‘lag’ maximizing their alpha. Though nonsensical, having real-time data is paramount.

Thus, though exploiting this phenomenon is plausible, it carries great risk, especially when executed by retail traders with no real experience and education.

[1] As of 18 March 2021 Market Close, Source: Bloomberg Markets

[2] As of 17 March 2021 2.13 PM, Source: Bloomberg Markets

[3] As of 17 March 2021 2.13 PM, Source: Bloomberg Markets