The key to understanding how ETFs work is the "creation/redemption" mechanism. It is 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’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 someone called 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 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, and 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 blocks of 50,000 shares.
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 (NAV), not the market value at which the ETF happens to be trading.
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 NAV.
Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities.
When this happens, the AP can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit.
Likewise, if the ETF starts trading at a discount to the securities it holds, the AP can snap up 50,000 shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit.
This arbitrage process helps to keep an ETF’s price in line with the value of its underlying portfolio. With multiple APs watching most ETFs, ETF prices typically stay in line with the value of their 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. That’s why you often see closed-end funds trading at massive premiums or discounts to their NAV: there’s no arbitrage mechanism available to keep supply and demand pressures in check.
The ETF arbitrage process doesn’t work perfectly, and it pays to make sure your ETF is trading at fair value. But most of the time, the process works well.
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 company 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, APs 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 the APs 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 they have portfolio turnover due to index changes or rebalances, but the fee for putting new money to work (or redeeming money from the fund) is typically paid by the AP. (Ultimately, investors entering or exiting the ETF pay these costs through the bid/ask spread.)
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.