What Is the ETF Creation / Redemption Mechanism?

The ETF creation and redemption process is a key feature that distinguishes exchange-traded funds from other investment vehicles, contributing to their popularity among investors seeking transparency, liquidity and low-cost access to diversified portfolios. 

Learn how the creation/redemption mechanism works, including its purpose and benefits and the importance of the arbitrage process. 

The ETF Creation and Redemption Process  

The creation and redemption process is a unique feature of exchange-traded funds (ETFs) that helps keep the market price of an ETF close to its net asset value (NAV). This process involves authorized participants (APs), typically large institutional investors or market makers that facilitate the buying and selling of ETF shares on the secondary market, playing a crucial role in maintaining the efficiency and liquidity of ETFs. 

Here’s a simple diagram explaining the ETF creation and redemption process: 

Here's a step-by-step explanation of the creation and redemption process: 

The ETF Creation Process 

Here’s an explanation of how the ETF creation process works: 

• AP determination: Authorized Participants (APs) are institutional investors or market makers that are approved by the ETF issuer to create and redeem ETF shares. 
• Creation basket: The AP assembles a portfolio of securities that mirrors the ETF's underlying index or strategy. This portfolio is known as the "creation basket" or "creation units." The basket is typically composed of the actual securities held by the ETF or a representative sample. 
• In-kind transfer: The AP delivers the creation basket to the ETF issuer. This transfer is typically done in-kind, meaning the AP exchanges the actual securities for newly created ETF shares rather than providing cash. 
• Creation of ETF shares: The ETF issuer creates new shares and delivers them to the AP in the agreed-upon quantity. These newly created shares increase the number of outstanding shares in the ETF. 
• Listing on exchange: The AP may choose to keep the new ETF shares or sell them on the secondary market. If sold on the secondary market, the shares are listed on the stock exchange, allowing individual investors to buy and sell them throughout the trading day. 

The ETF Redemption Process 

Here’s an explanation of how the ETF redemption process works: 

• AP determination: APs may choose to redeem ETF shares to the ETF issuer. The decision to redeem shares may be driven by factors such as market demand, arbitrage opportunities, or the need to acquire the underlying securities for other investment purposes. 
• Redemption basket: The AP notifies the ETF issuer of its intent to redeem shares. The ETF issuer provides the AP with a "redemption basket," specifying the securities that will be received in exchange for the redeemed ETF shares. 
• In-kind transfer: The AP delivers the ETF shares to the ETF issuer, and in return, the AP receives the specified securities in the redemption basket. This process is conducted in-kind to maintain the tax efficiency of the ETF. 
• Cancellation of ETF shares: The ETF issuer cancels the redeemed shares, reducing the total number of outstanding shares in the market. 
• Secondary market transactions: The AP may choose to hold the securities received in redemption or sell them on the secondary market. If sold on the secondary market, these securities are available for other investors to buy and sell. 

Who Creates or Redeems ETFs? 

Authorized Participants (APs) are responsible for creating and redeeming shares of ETFs. APs are typically large institutional investors or market makers that play a crucial role in the functioning and efficiency of the ETF market. The creation and redemption process, facilitated by APs, helps keep the market price of ETFs closely aligned with their Net Asset Value (NAV). 

For example, the AP assembles a portfolio of securities, or creation basket, that closely mirrors the ETF's underlying index or strategy. This creation basket consists of creation units, which are large blocks of shares that are exchanged in the creation and redemption process of ETFs. Creation units are typically the minimum size at which new ETF shares can be created or existing shares can be redeemed.  

What Is the Purpose of Creating and Redeeming Shares? 

The primary purpose and benefit of the creation/redemption mechanism is that it’s an extraordinarily efficient and fair way for funds to acquire new securities. Another key purpose and benefit of the creation/redemption mechanism is that it’s what keeps ETF share prices trading in line with the fund’s underlying NAV.  

A good way to appreciate all this is to compare ETFs to mutual funds. 

Creation and Redemption: ETFs vs Mutual Funds  

With ETFs, APs do most of the buying and selling. When APs sense demand for additional shares of an ETF—which manifests itself when the ETF share price trades at a premium to its NAV—they go into the market and create new shares. When the APs sense demand from investors looking to redeem—which manifests itself when the ETF share price trades at a discount—they process redemptions. 

By comparison, when investors pour new money into mutual funds, the fund company must take that money and go into the market to buy securities. Along the way, they pay trading spreads and commissions, which ultimately harm the return of the fund. The same thing happens when investors remove money from the fund. 

The system is inherently fairer than the way mutual funds operate. In mutual funds, existing shareholders pay the price when new investors put money to work in a fund, because the fund bears the trading expense. In ETFs, those costs are borne by the AP (and later by the individual investor looking to enter or exit the fund). 

In-Kind Creation and Redemption vs Cash Redemption 

In-kind creation and redemption and cash redemption represent two distinct methods by which ETFs manage the creation and redemption of shares. In an in-kind process, authorized participants exchange a basket of underlying securities with the ETF issuer to create or redeem shares, fostering tax efficiency and minimizing transaction costs. This mechanism also facilitates the arbitrage process, helping to maintain the ETF's market price close to its NAV.  

Conversely, cash redemption involves the exchange of ETF shares for cash, potentially resulting in tax implications and increased trading costs. The choice between in-kind and cash redemption methods depends on factors such as the ETF's investment strategy, market conditions, and regulatory considerations. A recent example of cash redemption use is with the new spot bitcoin ETFs.  

Arbitrage in the ETF Creation and Redemption Mechanism 

The arbitrage process helps to keep an ETF’s price in line with the value of its underlying portfolio. With multiple APs watching most ETFs, ETF prices typically stay in line with the value of their underlying securities.  

Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities. 

When this happens, the AP can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit. 

Likewise, if the ETF starts trading at a discount to the securities it holds, the AP can snap up shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit. 

This is one of the critical ways in which ETFs differ from closed-end funds. With closed-end funds, no one can create or redeem shares. That’s why you often see closed-end funds trading at massive premiums or discounts to their NAV: There’s no arbitrage mechanism available to keep supply and demand pressures in check. 

The Creation and Redemption Process and ETFs 

In conclusion, the ETF creation and redemption process serves as a fundamental mechanism underpinning the efficiency and liquidity of ETFs. By facilitating the in-kind exchange of large creation units between authorized participants and ETF issuers, this process helps maintain the market price closely aligned with an ETF’s NAV, allowing investors to buy and sell shares at fair and transparent prices.  

Ultimately, the creation and redemption mechanism contributes to the appeal of ETFs, providing cost-efficient, tax-effective and liquid investment vehicles for a wide range of market participants.