[This article comes from the Learn section of our website]
The process that enables an ETP to offer the return on a diversified basket of securities is commonly referred to as the “create and redeem mechanism.” The creation and redeem mechanism is the key to understanding how ETFs function, and how as a pooled investment vehicle they are often able to reduce expenses and increase transparency.
While it can be a bit complex on the surface, this elegant process is actually relatively easy to understand.
The Mechanism
Logically, in order to secure the returns of the FTSE 100, a physically replicated ETP must be backed by actual shares in the stocks in the FTSE 100 (or at least a representative sample). Since ETP trading generally happens between investors, how does the ETF acquire those stocks?
The key is a special group of institutional investors called “authorised participants” (APs). The AP is the only investor who can trade directly with the ETP issuer—but they have to do it according to certain rules.
If the AP wants new shares of an ETP, he or she has to acquire, in correct proportion, all the securities that the ETP wants to hold. The AP then delivers this basket of stocks to the ETF issuer in exchange for shares of the ETP. The AP can then sell these ETP shares to regular investors on the open market. This process creates shares of the ETP.
The process can also run in reverse to redeem shares. The AP delivers a basket of ETF shares, and gets all of the underlying securities, which can then be sold on the open market.
These aren’t small transactions, however—ETF issuers specify that the transaction must take place in creation unit lots, usually 50,000 shares of the ETF at a time.
The AP
So who are APs? They can be market makers, specialists or any large financial institution—essentially it’s someone with a lot of buying power.
Why bother being an AP? To make money.
Think about the above example, the AP showing up with all the securities in the FTSE 100, exchanging them for shares in the ETP. Why would they do that? Because if the ETP shares are overpriced versus the value of all those underlying stocks, they can make money by buying low and selling high—classic arbitrage (see "Premiums and Discounts").
If the ETP shares are trading below the value of all the securities, the AP can buy up 50,000 “cheap” shares, deliver them to the ETP issuer and get the higher-priced underlying securities in return.
How Does This Link Into An ETF’s Costs?
The beauty of the creation/redemption mechanism is that, beyond keeping prices in line, it’s an extraordinarily efficient and fair way for funds to acquire new securities.
Consider this: When investors pour new money into traditional mutual funds, the fund companies must take that money and go into the market to buy securities. Along the way, the fund will pay trading spreads and commissions, which ultimately detract from returns. The same thing happens when investors remove money from the fund.
With ETFs, APs do most of the buying and selling. They pay all the trading costs and fees, and even pay additional fees to the ETF provider to cover the paperwork involved in processing the creation/redemption activity. Existing shareholders in the fund are shielded from these costs. Moreover, the staffing and logistics management of managing the fund is lowered as well.
It’s simple: ETFs are cheaper to run, so ETFs are cheaper to own.
One additional note: The process is similar even for ETPs that don’t hold underlying securities but get their exposure through swaps. APs deliver and receive cash, and the ETP adjusts their swap exposure. The arbitrage mechanism still works, because the AP can hedge the other side of those trades with the basket on their own accounts.
