Creation and redemption: ETFs’ “secret sauce” explained

The creation and redemption process used by exchange-traded funds (ETFs) is the behind-the-scenes feature that drives many of their potential advantages. These typically include low fees, liquidity, and ETF tax efficiency.

ETF assets continue to grow as investors embrace their structural benefits. Combined assets in U.S. ETFs stood at $3.7 trillion as of May 31, 2019, according to the Investment Company Institute.¹

On the surface, the ETF structure seems fairly simple. At the most basic level, they’re baskets of securities, such as equities and bonds, that trade on an exchange, similar to individual stocks. However, understanding their benefits requires taking a look at ETFs’ complex inner workings. The ETF share creation and redemption process, which differentiates ETFs from traditional mutual funds, drives key advantages, from liquidity and lower cost to ETF tax efficiency.  

Meet the authorized participants

If ETF share creation and redemption is the “special sauce” of ETFs, it takes more than one cook to make it. In fact, it takes multiple players in the financial markets. At the center of this process are authorized participants (APs). These brokers, financial institutions, and market makers are the only entities that can interact directly with ETF sponsors to create and redeem large blocks of shares of the ETF—typically between 10,000 and 100,000 shares—called creation units, based on supply and demand for the ETF. An ETF usually has multiple APs.

Let’s start with how new ETF shares are created to meet demand. ETFs disclose their holdings daily so the APs know exactly what stocks and bonds are in the portfolio, and in what amounts. To create ETF shares in an equity ETF, the AP acquires the stocks in the basket and delivers them to the ETF provider. Then, the ETF sponsor uses the stocks to assemble ETF shares and deliver the shares of the ETF to the AP, which can release those shares in the secondary market to meet demand. 

During a redemption, the opposite takes place, which results in fewer ETF shares outstanding, therefore shrinking the assets of the ETF. Essentially, the creation and redemption process elastically controls the number of ETF shares outstanding, based on supply and demand. That’s another way of saying that the supply of ETF shares can be continually changed in response to demand.

Keeping ETF share prices in line

Investors obviously want a fair price when buying or selling ETF shares, and the creation and redemption feature helps facilitate that. Specifically, there is an arbitrage mechanism that helps keep the price of an ETF share in line with the net asset value (NAV) of the securities the ETF holds.

Arbitrage is a trading term that refers to the simultaneous buying and selling of the same securities to profit from price discrepancies in different markets. Because ETFs are open-ended funds and use the creation/redemption process, arbitrage is what generally prevents share prices from trading at premiums or discounts to NAV, as often happens in closed-end funds.²

If an ETF share price is trading above NAV due to strong demand, then the fund is trading at a premium. APs have a profit incentive to arbitrage that premium away. To do so, APs can create shares and then sell them in the open marketplace, locking in a profit on the spread between the ETF share price and NAV. Meanwhile, those newly created shares create more supply, which tends to push the ETF share price down closer to NAV. When the ETF is trading at a discount, the entire process is reversed.

Creation and redemption impact on ETF fees and taxes

The creation and redemption process has other benefits for ETF investors: It helps keep a lid on ETF fees, while also boosting ETF tax efficiency.

Regarding costs, it helps to compare an ETF to an equity mutual fund. When a mutual fund experiences net inflows, it must take the cash it receives and put it to work buying stocks or other securities in the open market. This results in the fund paying trading spreads and broker commissions. And when the fund has net outflows, it must sell securities to raise cash to meet investor redemptions.

On the other hand, ETFs have APs that are handling these transactions, rather than the ETF portfolio manager. This is one reason why ETFs can charge low fees, although it should be noted that ETFs have bid/ask spreads, unlike mutual funds.

Additionally, the creation and redemption feature can help limit tax liabilities for ETF investors. Remember, when an equity mutual fund has redemptions, it sells stock to raise cash. If the fund has to sell stocks that have risen in value, the transaction can trigger a capital gain within the fund that must be distributed to all shareholders. Therefore, mutual fund investors can be hit with capital gain taxes even if they don’t sell any shares.

ETFs have some defense against this: Investors can simply buy and sell shares among themselves on the exchange. These transactions take place between investors and not with the ETF—no cash is involved and no capital gains are distributed.

The creation and redemption process has another positive influence on ETF tax efficiency. When demand falls and ETF shares are redeemed, as discussed above, the ETF provider disassembles the ETF shares and provides the underlying stocks/components to the AP. These transactions are “in kind” and don’t involve cash, so they aren’t considered a taxable event for the ETF.

Additionally, the ETF provider can give the AP the stock that has appreciated the most (the lowest cost basis). This can help keep capital gains and taxes low for ETF investors.

Putting it all together, the creation and redemption process is something that takes place behind the scenes. However, this feature plays an important role in keeping ETFs liquid, lower cost, and tax efficient.

 

 

ETF Assets and Net Issuance, May 2019, Investment Company Institute. See the most recently available ETF data at https://www.ici.org/etf_resources/research/. 2 There can be no assurance that active trading markets for the shares will develop or be maintained by market makers or authorized participants, and there are no obligations of market makers to make a market in the fund’s shares or to submit purchase or redemption orders for creation units. Although market makers will generally take advantage of differences between the NAV and the trading price of fund shares through arbitrage opportunities, there is no guarantee that they will do so. Decisions by market makers or authorized participants to reduce their role with respect to market making or creation/redemption activities in times of market stress could inhibit the effectiveness of the arbitrage process in maintaining the relationship between the underlying value of the fund’s portfolio securities and the fund’s market price. This reduced effectiveness could result in shares trading at a discount to NAV and also in greater-than-normal intraday bid/ask spreads for shares.