The key to understanding how ETFs work is the “creation/redemption” mechanism. It’s how ETFs gain exposure to the market, and is the “secret sauce” that allows ETFs to be less expensive, more transparent and more tax-efficient than traditional mutual funds.
It lies at the heart of the ETF arbitrage mechanism. It's a bit complicated, but worth understanding.
The Role Of Authorized Participants
When an ETF company wants to create new shares of its fund, whether to launch a new product or meet increasing market demand, it turns to an authorized participant (AP). An AP may be a market maker, a specialist or any other large financial institution. But essentially, it's someone with a lot of buying power.
It is typically the AP’s job to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit. These blocks are usually formed in 50,000-share chunks (although sometimes they can be as high as 100,000).
The exchange takes place on a one-for-one, fair value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (and not the market value that the ETF happens to be trading at).
Both parties benefit from the transaction: The ETF provider gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit.
The process can also work in reverse. APs can remove ETF shares from the market by purchasing enough of those shares to form a creation unit and then delivering those shares to the ETF issuer. In exchange, APs receive the same value in the underlying securities of the fund.
Why Is The Creation/Redemption Process Important?
The creation/redemption process is important for ETFs in a number of ways. For one, it’s what keeps ETF share prices trading in line with the fund’s underlying net asset value, or NAV.
Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. So, should an ETF become more expensive than the sum of its underlying securities, an AP can buy up the underlying shares, form a creation unit and exchange it, and sell the ETF shares on the market. This process brings the ETF’s price back to its NAV.
Likewise, if the underlying securities become more expensive, then the AP can purchase a creation unit's worth of ETF shares and redeem them for their underlying securities, which can (again) be resold.
This is called arbitrage, and it helps to keep an ETF's price in line with the value of its underlying portfolio. Over time, these buying and selling pressures balance out, and the ETF's market price typically stays in line with the value of its underlying securities.
This is one of the critical ways in which ETFs differ from closed-end funds. With closed-end funds, no one can create or redeem shares past the initial offering. That's why you often see closed-end funds trading at massive premiums or discounts to their NAV; there is no arbitrage mechanism available to keep supply and demand pressures in check.
The arbitrage process doesn’t work perfectly, as we’ll discuss in our “Understanding ETFs’ True Costs” section.
An Efficient Way To Access The Market
The other key benefit of the creation/redemption mechanism is that it’s an extraordinarily efficient and fair way for funds to acquire new securities.
As discussed, when investors pour new money into mutual funds, the fund companies must take that money and go into the market to buy securities. Along the way they pay trading spreads and commissions, which ultimately harm returns of the fund. The same thing happens when investors remove money from the fund.
With ETFs, authorized participants do most of the buying and selling. When APs sense demand for additional shares of an ETF—which manifests itself when the ETF share price trades at a premium to its NAV—they go into the market and create new shares. When they sense demand from investors looking to redeem—which manifests itself when the ETF share price trades at a discount—they process redemptions.
The AP pays all the trading costs and fees, and even pays an additional fee to the ETF provider to cover the paperwork involved in processing all the creation/redemption activity.
The beauty of the system is that the fund is shielded from these costs. Funds may still pay trading fees if the fund changes its strategy or if there is an index change, but the fee for putting new money to work (or redeeming money from the fund) is typically paid by the AP.
The system is inherently more fair than the way mutual funds operate. In mutual funds, existing shareholders pay the price when new investors put money to work in a fund, because the fund bears the trading expense. In ETFs, those costs are borne by the ETF issuer looking to make a market in the fund.