The creation/redemption mechanism provides the framework for understanding the manner ETFs work. Through the mechanism, ETFs are able to enter the market. In addition, the creation/redemption mechanism is the driving force that makes ETFs affordable, secure, and tax efficient compared to the traditional mutual funds. Understanding the creation/redemption mechanism is a bit complicated, but the reward is worth the effort.

The Role of Authorized Participants

Authorized participants (AP) are individuals or entities that ETF companies consult when planning to float new shares in the market in order to develop a new product, or meet the increasing demand. Entities that can act as APs include specialists, market makers or large financial institutions. Put differently, an AP has to be an entity with a huge purchasing power.

The APs’ role is obtaining the securities that ETFs is interested in holding. For example, in cases where ETFs are tailored to keep track of the S&P 500 Index, APs would purchase shares in all the constituents with an S&P index of 500 with the exact weight as the index. The APs will then deliver the shares to an ETF provider. In reciprocation, the provider allocates the AP a block of shares that is equal to the value of ETF shares referred to as creation units. These units are normally constituted in blocks of 50,000 shares.

The above transaction is done on a one-for-one share basis anchored on fair value. The AP supplies a specific amount of securities and in turn receives a similar value in ETF shares. The price is determined by the net asset value (NAV), and not the current ETF market value.

The transaction is beneficial to both parties. The ETF provider benefits by obtaining the stock that is crucial in tracking the index, while the AP gets many ETF shares that are resold for a profit.

The above transaction can also be done in reverse. The AP provider can recall ETF shares from the market by buying large numbers of those shares to form a creation unit, and then resell the shares to the ETF issuer. In turn, the AP benefit by receiving a similar value in terms of securities.

More on Authorized Participants.

The Significance of the Creation/Redemption Process

The creation/redemption process plays a significant role in ETFs transactions in different ways. First, the process is what sustains the trading in ETF shares based on the funds underlying NAV.

ETF shares are traded like stock, and this means that the prices fluctuate during trading days because of supply and demand. For example, when the number of investors interested in purchasing the shares is high, the price of the shares might rise beyond the value of underlying securities.

In the above scenario, APs can intervene. The high, ETF prices might make an AP to purchase the underlying shares that constitute the ETF, and then auction the ETF shares on the stock exchange. This has the effect of lowering the price of the ETF shares to a fair value, while earning the AP risk-free brokerage profit.

Similarly, in cases where the ETF sells the securities it holds at a discount, the AP can repossess up to 50,000 shares of the ETF cheaply, and redeem them in terms of securities that can be resold. By acquiring the underpriced ETF shares, the AP lowers the price of the ETF shares to a fair value, while making a handsome profit.

The above transaction assists in keeping the price of the ETF shares, according to the value of underlying securities. This is the main difference between ETF shares and closed-end funds. The creation and redemption of funds is not possible with the closed-end funds. Hence, closed-end funds always trade at a premium price, or as a discount to the respective NAV. Arbitrage mechanisms, of regulating the pressure created by demand and supply are absent.

It is noteworthy that the ETF arbitrage process is not perfect, and it is important to make sure that the ETF you have invested in are trading at a fair value. However, in most cases, the arbitrage mechanism is effective.

Redeeming ETF Shares

Investors who are interested in selling their ETF shares can do so through two approaches. First, they can redeem the shares in the open market, and this is the most preferred option. Second, investors can acquire enough ETF shares to come up with a creation unit, and then sell the units for the underlying securities. Only institutional investors can benefit from this option because a big number of shares are needed to come up with a creation unit. When institutional investors redeem their shares, the creation unit stops to exist and the securities go back to the redeemer. The advantage of this option is the lower tax charged on the securities.

The tax benefits can be seen clearly by comparing the redemption of ETF to the redemption of mutual funds. When investors holding mutual funds redeem them, all shareholders in the fund shoulder the tax burden because they may have to sell the securities they hold for capital gain, which is subjected to tax.

ETFs lower the chances of the above scenario occurring by compensating large redemptions with the stock shares. In cases of such redemptions, the shares with the lowest impact on the cost in the trust are transferred to the redeemer. This increases the overall cost of shares held by the ETF, and lowers the capital gains.

An Effective Way of Accessing the Market

Another main advantage of the creation/redemption mechanism is that it is a very effective way for obtaining new ETF securities. When investors acquire mutual funds, the mutual fund company must use the money to buy securities in the market. The company will have to pay commissions and trading spreads, which lowers the return on the investment. A similar scenario is witnessed when an investor withdraws money from the trust fund.

In ETF trading, APs perform most of the tasks related to buying and selling. For instance, when APs realize that there is a demand for additional shares, which is evident when ETF shares trade at a premium price of its NAV value, APs proceed to the market to create new shares. On the contrary, when the APs sense that the number of investors willing to redeem shares has gone up, which is evident when ETF shares trade at a discounted price, the APs process the redemptions. The APs settle all the costs and fees associated with the transactions, even the additional fee ETF provider incur in paperwork and other redemption activities.