If demand for an ETF outstrips supply, the ETF would show a premium to its iNAV. Consequently, a market maker could step in to borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF, which are then sold to the public on the secondary market, alleviating the premium.
On the other hand, if an ETF shows a discount to its iNAV, a market maker can reverse the process and redeem ETF shares for a basket of underlying stocks.
The creation and redemption process is an important factor that allows large investors to ease into an ETF position.
For example, JPMorgan Diversified Return Europe Currency Hedged Equity ETF (NYSEArca: JPEH) and JPMorgan Diversified Return International Currency Hedged Equity (NYSEArca: JPIH), which began trading early April, are still new and understandably less widely known. Consequently, the two have exhibited low trading activity – JPIH shows an average daily volume of 1,200 shares and JPEH has an average 5,067 shares, according to Morningstar data. [Read: J.P. Morgan Expands into Currency-Hedged ETFs]
Nevertheless, on Tuesday, large trade orders were successfully executed on the two funds. JPIH saw 961,000 shares traded and held $25.6 million in assets under management, but the ETF is only trading at a 0.29% premium to its net asset value. JPIH was up 3.2% at mid-day. Similarly, JPEH saw 970,588 shares traded and held $25.5 million in AUM, but the ETF is only trading at a -0.03% discount to its NAV. JPEH was down 0.1% at last check.
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. 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.
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