ETF Creation
The creation and redemption process for ETF shares is almost the exact opposite of that of mutual fund shares.
Investing in mutual funds
- Investors send cash to the fund company,
- Fund Company uses that cash to purchase securities and in turn issue additional shares of the fund.
- When investors wish to redeem their mutual fund shares, the shares are returned to the mutual fund company in exchange for cash.
The creation of an ETF, however, does not involve cash.
The process
- Begins when a prospective ETF manager (known as a sponsor) files a plan with the SEC to create an ETF.
- The plan is then approved by SEC
- The sponsor forms an agreement with an authorized participant, generally a market maker, specialist or large institutional investor, who is empowered to create or redeem ETF shares. (In some cases, the authorized participant and the sponsor are the same).
- The authorized participant borrows shares of stock, often from a pension fund, and places those shares in a trust, and uses them to form creation units of the ETF.
- Creation units are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares is what’s commonly designated as one creation unit of a given ETF.
- The trust provides shares of the ETF – which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units) – to the authorized participant.
Because this transaction is an in-kind trade – that is, securities are traded for securities (the authorized participant provides shares of stock to the trust and the trust in turn provides ETF shares to the authorized participant) and no cash changes hands – there are no tax implications.
- Once the authorized participant receives the ETF shares, the shares are then sold to the public on the open market just like shares of stock.
- When ETF shares are bought and sold on the open market, the underlying securities that were borrowed to form the creation units remain in the trust account.
- The creation units are not impacted by the transactions that take place on the market when ETF shares are bought and sold.
- The trust generally has little activity beyond paying dividends from the stock held in the trust to the ETF owners and providing administrative oversight
ETF Redemptions
When investors want to sell their ETF holdings, they can do so by one of two methods.
- To sell the shares on the open market. Generally the option chosen by most individual investors.
- To gather enough shares of the ETF to form a creation unit
– Exchange the creation unit for the underlying securities.
– This option is generally only available to institutional investors due to the large number of shares required to form a creation unit.
– When these investors redeem
– The creation unit is destroyed and the securities are turned over to the redeemer.
– The beauty of this option is in its tax implications for the portfolio.
- When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by tax burden because to redeem the shares, the mutual fund may have to sell the securities it holds, realizing the capital gain, which is subject to tax.
- ETFs minimize this scenario by paying large redemptions with shares of stock.
- When the redeemer sells the shares of stock on the open market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios.
The Role of Arbitrage
Critics of ETFs often cite the potential for ETFs to trade at a share price that is not aligned with the value of the underlying securities. To help us understand this concern, a simple representative example best tells the story.
Assume an ETF is made up of only two underlying securities:
- Security A, which is worth $1 per share
- Security B, which is also worth $1 per share
In this example, most investors would expect one share of the ETF to trade at $2.00 per share (the equivalent worth of Security A and Security B). While this is a reasonable expectation, it is not always the case. It is possible for the ETF to trade at $2.02 per share or $1.98 per share or some other value.
If the ETF is trading at $2.02, investors buying shares of the ETF are paying more for the shares than the underlying securities are worth. This would seem to be a dangerous scenario for the average investor, but in reality, it isn’t a major problem because of arbitrage trading.
How arbitrage sets the ETF back into equilibrium.
- The trading price of an ETF is established at the close of business each day, just like any other mutual fund.
- ETF sponsors also announce the value of the underlying shares on a daily basis. When the price of the ETF deviates from the value of the underlying shares, the arbitragers spring into action.
- If the underlying securities are trading at a lower price than the ETF shares, arbitragers buy the underlying securities, redeem them for creation units, and then sell the ETF shares on the open market for a profit.
- If underlying securities are trading at higher values than the ETF shares, arbitragers buy ETF shares on the open market, form creations units, redeem the creation units in order to get the underlying securities, and then sell the securities on the open market for a profit.
- The actions of the arbitragers set the supply and demand of the ETFs back into equilibrium to match the value of the underlying shares.
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