I was just wondering how the fair price of ETF with international holdings are accurately priced. Say we have an ETF that trades on domestic exchange but the holdings are international and the market is closed i.e. we do not have the spot prices of the underlying holdings. How then can the ETF market makers accurately price the underlying holdings? From my understanding, one way to do so would be through the use of futures contracts for the stocks but I'm not sure how that is being done. Can someone shed light on this/provide an alternative? Thank you!
Pricing an ETF always involves estimation. Most ETFs have a regular trading market that is only a few bps wide. Even in the US we often have ETFs with relatively illiquid underlyers but with an ETF that is priced tight.
Market makers look for all kinds of proxies to model the fair value of ETFs. For international ETFs it will be a combination of ADR's, foreign futures (Kospi, TOPIX, etc), and related local equities. As the clock cycle moves and some products become more - or less - liquid the market maker will adjust the way that the ETF price is projected from relevant underlying securities.
The goal of this constructive pricing is to come up with a fair value for the ETF. This is a precise number. We might determine that the fair value for a given security is \$100. That means that we will be willing to buy for \$99.9999999 or sell for \$100.00000001. But, there are frictions. It might cost another \$.02 to carry all of the underlying components. So now that means I will buy the ETF for \$99.979999999999 or sell it for \$100.0200000000001.
But, why would I want to do that? I'll try to buy the ETF for \$99 and sell it for \$101. OK, but then all of my competitors will cut that margin. Then I'll cut the margin. And pretty soon you are down to a market that might trade very close to fair value. And then put on top of that the possibility that you have people with real flow. For example, a customer puts in an order to a bank to buy 1mm sh. The bank might start working that order in the middle of the spread. So now, when you look at the market you will see the ETF bid over fair value!
Such is life.