The term ‘Exchange-Traded Fund’ (ETF) is often used in the investment world, but many people do not know what an ETF is. Exchange-traded funds are essentially mutual funds that trade like stocks on a stock exchange. They differ from traditional mutual funds in two ways: an ETF only invests in securities, and it trades during the day like a stock. By selling their shares throughout the trading session, investors can gain from an increase or decline in share prices.
There must be a mechanism through which new ETFs can enter the market and old ones can be removed for this to work. In other words, there needs to be a process by which new shares of an ETF, known as creation units, are brought into existence, and existing shares can be liquidated.
So how does this work?
The ETF issuer creates new shares in the primary market. The price of these new shares is established by an open auction between purchasers and sellers or may also be based on a formula that calculates the fair value of the ETF’s holdings. When the market price of an ETF share deviates from its net asset value (NAV), arbitrage opportunities arise.
Shares in an ETF are not created out of thin air. They do not appear magically because somebody decided to create them at random – they come about as a result of investments into the underlying securities which make up the fund’s portfolio. When investors buy and sell these funds, it is not like buying and selling a stock. The fund is not a company with a certain number of shares outstanding, and investors do not buy fractions of those shares – they only transact in the underlying securities.
So when an investor buys equity X at $10 per share, it must first be sold to the ETF issuer for $8 (or whatever the NAV happens to be). The issuer then uses this cash to purchase 25% of company Y for $5 a piece (Y also has 100 million outstanding shares) and 50% of Z for $2.11 each (Z has 75 million shares outstanding). The next day, you can sell your shares back to the issuer for their respective market value based on the NAV.
The process outlined above is the process of creation and redemption, through which ETFs can be created or destroyed.
The mechanics of creation and redemption
ETF shares are created by an authorized participant (AP) purchasing its underlying securities on behalf of the fund in exchange for Creation Units. Creation Units are large blocks of hundreds or even thousands of individual shares that each contain a certain amount of assets.
The issuer then delivers these assets to the AP, dividing them into smaller lots called creation units. They then sell those creation units into the market as required, usually at a slight premium to NAV, alongside an equal number of inverse creation units which they simultaneously purchase from another market participant. In doing so, they effectively remove one set of shares from circulation and replace them with a new set.
A participating AP earns a profit from the premium paid for the creation units it has created and receives a fee from the fund’s sponsor as compensation for its services. This is an incentive to create and redeem large blocks of shares as quickly as possible, which ensures that market prices remain close to NAV.
It’s important to note that there is no ‘outside party’ involved in this process. The AP does not profit from anyone purchasing or selling the creation units – it simply acts as an intermediary between maker and taker orders, entering into two offsetting trades simultaneously. Because it makes money simply as a function of time (the longer each trade remains open, the more profitable it becomes), the motivation for an AP to carry out creation and redemption transactions as quickly as possible is high.
The role of authorized participants
Authorized participants are select broker-dealers who have entered into specific agreements with ETF issuers to distribute their products. This allows them to engage in customized trading without committing too much capital on every transaction since they can only sell ETF shares by creating or redeeming them through APs.