A distinguishing aspect of Exchange Traded Funds (ETFs) is that investors buy and sell them on a stock exchange. The company managing the fund (the issuer) does not sell ETF shares directly to individual investors. Likewise, the issuer does not buy shares back from selling fundholders. This article explains how those transactions are related to the “creation and redemption” process that separates individual investor transactions from the ETF issuer.
Creating new ETF Shares
When an ETF is created, the issuer works with a big financial institution known as an Authorized Participant (AP). The AP goes into the open market and buys the securities that make up the ETF.
The AP exchanges this big basket of securities with the issuer for a large block of shares of the ETF. This big block is referred to as a creation unit.
That creation unit is resold by the AP on the stock exchange where shares of the fund will trade. Each share of the ETF can then be bought or sold by individual investors.
After that, the AP manages the supply of outstanding ETF shares to meet ongoing investor demand. When necessary, this includes creating additional ETF shares from the issuer for sale on the exchange.
Redeeming Outstanding ETF Shares
When there are more sellers than buyers of the ETF, the AP may work with the issuer to take excess supply off the market. This defines the redemption process. It is the opposite of the creation process.
The AP will go into the open market and buy shares of the ETF. After accumulating a large block of ETF shares – referred to as a redemption unit – the AP will exchange those shares for an equivalent value of the basket of securities that make up the ETF. The AP may then sell those securities in the open market.
Summary of the Creation and Redemption Process
Creation and redemption involves shares of the ETF and shares of its component basket of securities. A small cash component is also typically included in either process.
The AP does ultimately sell those huge quantities of ETF shares or its component securities. It will sell ETF shares acquired in the creation process and shares or its component securities acquired in the redemption process. But those sales take place in the open market. They do not include the issuer.
The transactions the AP makes in the creation or redemption process may have tax consequences for the AP, as buying and selling on its own behalf may create taxable events. The AP’s market activity has no impact to the fund, which by law is required to pass through cap gains to shareholders.
Exchanges between APs and issuers are “in-kind transactions”, which are typically tax-free events. APs trade ETF shares for portfolio securities (and vice versa). There technically are no purchases or sales between the two entities.
Notable Effects of Creation and Redemption
The ETF creation and redemption process produces a number of significant results.
For the ETF issuer, they help avoid the administrative burden of managing large cash inflows and outflows. Swapping ETF shares for portfolio securities helps eliminate the unexpected necessity to make changes (like selling securities to meet fundholder redemptions) in the underlying portfolio.
The effect for ETF investors is that other fundholders’ redemptions (sales) don’t create a tax consequence or incur transaction costs for them. This is because the ETF issuer doesn’t have to sell securities to cash out selling fundholders.
An investor may create a taxable event for himself or herself by selling shares of an ETF, if the ETF is sold for a profit, and some trading platforms charge commissions. But his or her sales won’t subject any other fundholder to an unexpected taxable gain or loss.
The creation and redemption process doesn’t eliminate any of the inherent investment risks that come with ETFs. Investors should consider the specific risks of a given ETF in light of their individual financial circumstances and unique risk tolerances. Reading an ETF prospectus can help.
Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.