Conversely, ETF shares can 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.
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.
By outlining the inner workings of ETF trades, advisors and large investors should understand why it is important to more carefully execute trades with limit orders instead of market orders. Specifically, a market order would guarantee an execution on trades, but it could send an ETF’s price surging while the underlying NAV remains the same. Consequently, an AP would quickly arbitrage the difference away at a significant cost to the trader. [Trading ETFs: Why Use Limit Orders]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.