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.
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.
Advisors who are executing larger orders would then be more interests in an ETF’s implied liquidity.
“ETF implied liquidity is a representation of how many shares can potentially be traded daily in an ETF as portrayed by the creation unit,” Rosenberg said. “This is defined as the smallest value of the IDTs – implied daily tradable shares – for each holding in the creation unit.”
Advisors and investors interested in large ETF trade orders may find help through a capital markets desk to help execute a new position in a relatively inactive ETF with limited market impact.
Financial advisors who are interested in learning more about the best practices for trading ETFs can listen to the webcast here on demand.