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How ETF Component Returns and Arbitrage Keep SPY Near Its Index

Article Quant Q&A · Author: gotiredofcoding
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Summary

The document explains what it means for SPY to track the S&P 500. The fund seeks to hold component weights close to those in the index, so its net asset value changes with the weighted returns of its holdings, after fees and expenses. The difference between the fund’s return and the index’s return is called tracking error.

The answer describes arbitrage as a force that can counter a sufficiently large gap between SPY’s market price and the value implied by its constituents, assuming tracking error is small. It therefore links constituent prices to fund value while recognizing that SPY itself trades in the market. The explanation is qualitative: it gives no data or estimate of tracking error, no account of how creation and redemption work, and no conditions or costs for arbitrage. It also does not establish that every short-term price move in SPY must match the moves of individual holdings.

Key ideas

  • SPY seeks to maintain holdings whose weights resemble those of the S&P 500.
  • The fund’s net asset value reflects weighted constituent returns, less fees and expenses.
  • Tracking error describes the difference between fund returns and index returns.
  • Arbitrage may reduce sufficiently large price gaps when tracking error is small.

Tags

EquitiesUS marketsArbitragePortfolio construction
Full text
# How SPY ETF really works?


# How SPY ETF really works?












So this is very confusing. If you read online they say that:

> "SPY is an exchange-traded fund (ETF) that tracks the Standard & Poor's 500"

Now the word "track" is super confusing and sound passive. I may understand one of these:

- If it track those 500 companies, that means they affect SPY, but SPY doesn't affect them with it's own demand.

- When I buy SPY I basically bought all of those 500 companies, which means the price of SPY is affected both by the demand of it's own stock, and also by all the stocks it represents(eg Apple), and it also mean that if i buy SPY I basically affect Apple and Amazon's stocks demand.

Sometimes, it seems (like now) that most stocks goes down and SPY doesn't, which makes me wonder, again - who affect SPY - those who buy the SPY ETF itself, or those who buy the companies it represent ?

## Answer by SuavestArt (score 2, accepted)

https://quant.stackexchange.com/a/73787

SPY returns, like any other ETF, are fully explained by the weighted returns of its components + any fees & expenses. It tracks the S&P in the sense that the fund's management tries to keep those weights as close as possible to the weights in the index. Any difference between the index returns and the ETF returns are referred to as the fund's tracking error.

Supposing that SPY's tracking error is close to zero, any sufficient increase/decrease in the ETF's market price that isn't explained by changes in its constituent's prices could be arbitraged away.

Higher prices of the constituents drive the fund's NAV up, which in turn makes the ETF price go up.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.