Exchange traded funds help advisors and investors gain exposure to broad areas of the market or focused segments through an easy-to-use investment vehicle. However, people should understand how their ETFs are traded.
Specifically, ETFs trade in two distinct markets: the secondary markets that everyone typically monitors on a stock exchange and the primary market where specific authorized participants help create and redeem ETF shares, writes Grant Englebart, portfolio manager at CLS Investments, for InvestmentNews.
Everyone should be familiar with the secondary market as it refers to the on-screen, quotable market that we track through price changes on the stock exchange, similar to tracking a company’s stock.
However, ETFs are also traded on a primary market where APs and the ETF sponsor help create and redeem ETF shares for underlying securities or holdings, which occur at the net asset value of the ETF, through so-called in-kind transactions.
The creation and redemption process helps keep an ETF trading near its NAV and allows large traders to go in and out of what appears to be an ETF with low liquidity. For instance, if an advisor or investor is interested in taking large order on an ETF that only trades on a couple thousand shares per day, he or she would contact a broker or authorized participant. The AP would come back with a quote and the investor would pay the broker the necessary commission.
Behind the scenes, the AP would tap into the underlying benchmark to acquire the necessary liquidity to back the large ETF trade. Tauthorized participants or large institutional investors would swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
If demand for an ETF outstrips supply, the AP 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. Consequently, the authorized participant exchanges the basket of stocks for ETF shares, which are then sold to the public on the secondary market.
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. [Volume is not the Best ETF Demand Indicator]