The way shares in ETFs are created and destroyed is an important financial innovation that gives them an edge over mutual funds – writes Dominique Riedl

Creation and redemption is the act of bringing new ETF shares into being when demand is high and winking them out of existence when demand falls away. It’s a mechanism that’s common to both ETFs and mutual funds but, like flight in modern birds, the ETF version has evolved into a more efficient dynamic than that used by its older mutual fund relative.

Unlike in a mutual fund, ETF investors do not have to bear the costs of buying and selling the securities within the fund needed to track an index. Instead the ETF issuer contracts Authorised Participants (APs) to gather the underlying securities required. APs are usually large financial institutions (think the trading desk of a global investment bank) and market makers that can operate cost effectively in the capital markets.

Shares in an ETF are created when an AP hands over a basket of securities to the issuer that matches the assets tracked by the ETF. The issuer lodges these securities with an independent custodian and gives the AP a ‘creation unit’ in exchange.

The creation unit is a block of shares in the ETF that represents the equivalent Net Asset Value (NAV) of the underlying securities. In other words, each ETF share gives you exposure to a sliver of the securities tracked by the ETF and stored with the custodian.

ETF creation/redemption in action

Consider the case of a physical FTSE 100 ETF:

The AP delivers a basket of FTSE 100 shares in line with the index weightings published by the issuer in its daily portfolio composition file (PCF). The FTSE 100 shares are held by the ETF’s custodian.

The AP receives an ETF creation unit in exchange. This amounts to a large batch of shares in the FTSE 100 ETF. 50,000 shares is standard but it can be as high as 100,000 or as low as 10,000.

The AP is now free to sell those ETF shares on the stock exchange where they can be traded by institutional players (e.g. brokers and hedge funds) and retail investors (i.e. you and me) who want exposure to the FTSE 100.

The AP makes a profit on the ETF shares by charging spreads, smart management of its securities inventory, and arbitrage (see below).

The exchange between the AP and the ETF issuer is known as the Primary Market whereas ETF trades on the stock exchange are referred to as the Secondary Market.
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The redemption process works just the same but in reverse. An AP buys up ETF shares on the stock exchange until it has a creation unit’s worth (e.g. 50,000). The ETF shares are then given back to the ETF issuer who redeems them for the equivalent value in the underlying securities.

ETF creation/redemption advantages

The ETF investor is shielded from market costs such as spreads and commissions because these transactions are typically handled by the AP. That stands in contrast to mutual fund managers who must trade securities directly in the market when investor demand outstrips supply, or investors clamour for their money back and the managers are forced to make net redemptions.

These underlying trading costs aren’t included in a fund’s OCF but instead bubble up through tracking difference.

Long-term investors are also spared the hidden costs of trading by speculative investors who quickly flip their funds. This perennial problem for mutual funds is solved by the ETF’s spread which pushes the expense onto investors as they enter and exit.

Even then, the spreads on large, high-volume ETFs are generally narrow because AP’s can often manage demand for the underlying securities from their large inventories as opposed to incurring trading costs in the market. In addition, the creation cost incur only once and the higher the turnover of ETF shares, the lower the marginal cost per share.

The creation / redemption process also controls supply and demand pressures through arbitrage so that investors don’t have to worry about their ETF’s NAV veering away from the underlying value of its securities.

ETF creation/redemption arbitrage

If an ETF becomes cheaper than its underlying securities then the AP will buy ETF shares in the Secondary Market and redeem them with the issuer. The issuer must hand over the underlying securities and the AP can now sell them for a profit in the stock market because they are worth more than the value of the ETF.

The AP will keep buying undervalued ETF shares and then selling the higher valued securities until prices are equalised again and there’s no more profit to be made.

The same happens in reverse if an ETF is overvalued in comparison to its underlying securities. The AP buys the cheap securities and exchanges them for ETF shares with the issuer. The more valuable ETF shares are then sold, netting arbitrage profits, until supply and demand pushes their prices back in step.

Because ETFs typically have several APs, there is intense competition to scoop the arbitrage profits quickly. That prevents a single AP allowing a large premium or discount to open up and ensures that most ETFs trade at or close to fair value.

Variations in creation and redemption

The creation / redemption process is a little different for synthetic ETFs. APs assigned to synthetics typically pay for a creation unit with cash. In that instance, the ETF issuer buys any required securities or adjusts the swap agreement that delivers the ETF’s return.

Whereas most physical ETFs use the ‘in-kind’ process described earlier, APs can hand over a sample of the ETF’s securities plus some cash.

This may well happen for exotic ETFs when the underlying securities are less liquid and therefore more expensive to trade. Note, it’s the liquidity of the underlying securities that is your best guide to the liquidity of the actual ETF. The daily trading volume of a relatively small ETF is unlikely to be a problem when the underlying securities can be easily traded and therefore quickly created and redeemed as supply and demand for the product fluctuates
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