Exchange traded funds are listed and traded like stocks on an exchange. However, there are mechanisms at work behind the scenes that help the ETFs work like they do.
Specifically, investors have to understand that the creation and redemtion process makes ETFs a transformative investment structure, according to alletf.
ETFs are based of a portfolio of stock holdings, and the ETF’s price reflects the collective movement of its underlying holdings.
Unlike mutual funds, ETFs do not sell holdings in exchange for cash, which would trigger a taxable event. Instead, the ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa. [ETF ‘In-Kind’ Redemptions Help Limit Capital Gains]
An authorized participant would borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF. The Trust would provide shares of the ETF that are legal claims on the shares held in the ETF. As such, the authorized participant exchanges the basket of stocks for ETF shares, which are then sold to the public as stocks in the open market.
Conversely, ETF shares may be exchanged for a basket of securities from the underlying benchmark. Someone would have to hoard enough ETF shares to form a creation unit and then exchange the creation unit for shares of the underlying securities.