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.
A liquidity provider can facility ETF buy and sell orders that comes through exchanges, providing liquidity on both sides of the market for the duration of a trading session. The liquidity provider sells to the market as an investor wants to buy an ETF. The liquidity provider will go long the underlying stocks that make the ETF why going short the ETF to hedge his position.
Once demand for an ETF reaches the size of a creation unit, or about 50,000 shares, a liquidity provider can put in an order for a unit to an Authorized Participant who will go to the actual ETF issuer to exchange the in-kind portfolio of component securities for a creation unit of the ETF, relieving the short ETF position.
For sell orders, the liquidity provider buys ETFs from the public and sells short the basket of underlying securities. If enough orders are processed to hit a creation unit, the liquidity provider can submit an order to redeem his position of 50,000 shares in an ETF through an Authorized participant.
However, there are some exceptions. For instance, some exchange traded note providers have halted new share issuance before, which have caused the investments to trade at a steep premium or discount to their net asset value.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.