The Creation/Redemption Mechanism

[This article originally appeared in our June 2016 issue of ETF Report. For ETF education, see our ETF University section.]

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—as well as closed-end funds, which also have no creation/redemption capacity.

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. Essentially, it's someone with a lot of buying power.

It's 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 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.

It should also be noted that APs basically take on all the trading costs and fees, like spreads and commissions, when creating or redeeming shares. That means the ETF is largely shielded from those costs, and returns (and existing shareholders) are unaffected when new money enters a fund.

Why Is The Creation/Redemption Process Important?
The creation/redemption process is important for ETFs in another key aspect: 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.