ETF Basics
How ETFs work?
Key Takeaways
Authorized Participants (AP) manage the creation and redemption of ETF shares.
The creation/redemption process seeks to reduce operating expenses, provide transparency and tax efficiency, and keep the ETF share prices trading in line with the fund's underlying NAV.
So how do ETFs work?
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 many ETFs to be more cost-efficient, transparent, and tax-efficient than many traditional mutual funds.
Unlike mutual fund shares, retail investors can only purchase and sell ETF shares in market transactions. So ETFs do not sell individual shares directly to or redeem their shares directly from retail investors.
Instead, ETF sponsors have contractual relationships with one or more financial institutions known as Authorized Participants - typically large broker-dealers. Only APs are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks (e.g., 50,000 ETF shares) commonly called "Creation Units."
To purchase shares from an ETF, an AP assembles and deposits a designated basket of securities and cash with the fund in exchange for which it receives ETF shares. Once the Authorized Participant receives the ETF shares, the AP is free to sell the ETF shares in the secondary market to individual investors, institutions, or market makers in the ETF.
The redemption process is the reverse of the creation process. An AP buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the AP receives a pre-defined basket of individual securities or the cash equivalent.
An ETF's market price typically will be more or less than the fund's NAV per share. This is because the ETF's market price fluctuates during the trading day because of a variety of factors, including the underlying prices of the ETF's assets and the demand for the ETF, while the ETF's NAV is the value of the ETF's assets minus its liabilities, as calculated by the ETF at the end of each business day. An ETF's market price is generally kept close to the ETF's end-of-day NAV because of the arbitrage function inherent to the structure of the ETF.
Arbitrage is the practice of taking advantage of a price differential between two or more markets. An arbitrage opportunity is inherent in the ETF structure because the ETF's intraday market price fluctuates during the trading day. Due to this fluctuation, the ETF's intraday market price may not equal the ETF's end-of-day NAV. AP can arbitrage this difference (and make a profit) because they can trade directly with the ETF at NAV as well as on the market. The expected result of the arbitrage activity is that the market value of the ETF moves back in line with the ETF's NAV per share, and investors can buy ETF shares on an exchange at a price that is close to the ETF's NAV per share.
Why is the creation/redemption process important?
The creation/redemption process is important for ETFs. It helps keep ETF share prices trading in line with the fund's underlying NAV.
Another key benefit of the creation/redemption mechanism is that it's an extraordinarily efficient way for funds to acquire new securities. Because of this, investors may be able to benefit from lower total operating expenses and better tax efficiency compared to mutual funds.
All investments involve risks, and that is true for ETFs, but with the proliferation of ETFs, investors have additional choices when building a diversified portfolio. We will share more pros and cons of ETFs in future courses.