[This article appears in our January 2020 edition of ETF Report.]
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’s a bit complicated, but worth understanding.
Why It’s 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 authorized participant 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.
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. 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.)
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 or departing investors sell their shares, because the fund bears the trading expense. In ETFs, those costs are borne by the AP (and later by the individual investor looking to enter or exit the fund).