Understanding the ETF creation and redemption process forms the basis of deciphering how ETFs function.
Not only does the process differ greatly from that of a mutual fund, but it gives ETFs benefits over mutual funds such as increased tax efficiency and better tracking. Creation and redemption is the factor granting ETFs their considerable liquidity, as well as their ability to maintain their underlying securities’ value. The latter is a major reason ETF investors are confident the price of their ETF shares is fair, whether purchasing or selling.
In this article, we’ll perform a deep dive into how new shares of ETFs are created and how existing shares are redeemed. We’ll also briefly touch upon the tax advantages of ETFs over their mutual fund counterparts.
The primary market, at the fund level, is where ETF creation and redemption takes place.
Institutional trading desks and other “Authorized Participants” (APs) exchange in-kind securities or cash for ETF shares, and then redeem the ETF shares back to cash or securities.
This creation and redemption process of shares ensures the ETF’s price is commensurate with its net asset value. It also makes sure ETF liquidity is based on the fund’s underlying securities.
ETF shares may increase or decrease on demand, but it is the AP who determines the demand, not individual investors.
In the United States, creation begins when a potential ETF manager, or sponsor, files an ETF creation plan with the U.S. Securities and Exchange Commission. Once the SEC approves it, the sponsor collaborates with an AP, who has the ability for creation and redemption of ETF shares. The AP and the sponsor may prove the same party, but most ETFs have multiple APs upon initial creation.
The AP then goes about borrowing shares of stock. Those shares are then placed in a trust. They will later form ETF creation units. The standard creation unit involves 50,000 shares per each ETF, although the stock bundles per se may consist of a much lower or higher number of shares.
The trust then gives the AP ETF shares, or more accurately, legal claims on the shares held in the trust. The AP then either sells the shares on a publicly traded exchange, or holds on to them. The “in-kind” trading by the AP of securities for securities means it is tax-exempt.
Keep in mind that ETFs disclose holdings daily, so APs are always aware of the underlying securities are included and their amounts.
For individuals, redeeming ETF shares simply consists of selling them via their broker. Institutional investors have an alternative. They may sell sufficient ETF shares to equal a creation unit, and then either redeem or exchange them for the securities. The creation unit then closes, and the institutional investor receives the securities instead. Again, because this action is “in-kind,” it avoids taxes.
How It Works
For a real-world example, take an investor who calls her broker and wants to purchase 750,000 shares of an ETF. Those shares are sold at a particular price to the investor.
As far as she is concerned, the process is done. However, for the broker, an AP, the process is just starting. The AP knows that the investor has just increased demand with her purchase, and now he must create new ETF shares. Because he sold those 750,000 ETF shares, he is now short.
After purchasing a basket of securities the ETF holds, the AP is now hedging himself. In other words, he is short on the ETF and long on the basket of securities. Once that basket is received by the ETF’s issuer, a creation occurs. The issuer then sends the new shares to the AP, and the AP’s ETF position is now flat.
For a redemption, the opposite happens. The investor tells the broker to sell her 750,000 ETF shares. The AP buys them from her at the agreed price. If there is now a reduction in demand due to the sale, the AP is now in a long position. He then sells the ETF’s basket of securities to put him in a short position for the basket while remaining long on the ETF.
When the ETF issuer receives the shares, a redemption takes place. Once the AP receives the basket of securities, he reaches a flat position on the basket.
Arbitrage and Creation and Redemption
Of course, an ETF’s price is subject to supply and demand. The AP may play the role of arbitrager, as they can add and remove ETF shares so supply and demand becomes more balanced. Arbitrage refers to purchasing and selling the same securities simultaneously in order to take advantage of price differences in various markets. Arbitrage prevents the trading of ETF shares at either premium or much lower amounts than net asset value.
Should the ETF shares start trading above the level of the underlying securities, the AP then goes into creation mode. The less costly underlying securities are purchased and then exchanged for ETF shares. Should the opposite occur and the ETF shares are less expensive than the underlying securities, the APs buys those ETF shares and redeems them for the underlying securities.
Such arbitrage allows APs to assist investors in keeping the price of ETF shares in line with that of its underlying securities.
ETF Tax and Fee Benefits
The creation and redemption ETF structure offers numerous tax benefits over mutual funds.
When any mutual investor redeems his or her shares, all shareholders are affected. That is because capital gains comes into play when the securities are sold.
Because mutual funds must pay out all capital gains and dividends annually, investors may find themselves with a tax bill even if the portfolio lost money. Mutual fund investors may often find themselves with a large capital gains tax bill even though they personally did not sell any shares.
When there is a large ETF redemption, the effect is minimal since these redemptions are payable via stock shares. The entity redeeming the shares receives those with the lowest cost basis. Because the overall ETF holdings then experience a cost basis increase, the effect on capital gains is lessened. The redeemer’s tax basis is determined by the cost of the original shares, not the cost basis of the fund.
In addition to tax benefits, ETF investors also come out ahead in relation to fees. Because it is an AP and not a portfolio manager who is making transactions, the fees are much lower compared to a mutual fund. An ETF does have spreads for bid and ask, which is not true of mutual funds.
Now that you’ve received a behind the scenes look at how ETFs operate, you can comprehend the numerous benefits of the complex creation and redemption process.
This article examined the process that occurs when new ETF units are created or redeemed. We also briefly discussed the tax advantages of ETFs relative to mutual funds.
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