“When one investor sells ETF shares and another investors buys them on the exchange, the underlying securities of the ETF don’t need to be sold in order to raise cash for the redemption,” Invesco PowerShares notes.
Furthermore, trading firms known as authorized participants or APs are responsible for working with the ETF manager to create and redeem large blocks of shares, called creation units. These exchanges are “in-kind” transactions that involve stock rather than cash.
These large creation units are created and redeemed based on demand for the ETF, and selling pressure. [Creation and Redemption Explained]
“An in-kind redemption process enables the fund manager to purge the lowest cost-basis stocks through stock transfers during the creation and redemption process,” according to Invesco PowerShares. “The result may be greater tax efficiency because shareholder activity and resulting portfolio turnover don’t affect the portfolio to the same extent as with mutual funds.”