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How is ETF Share Created and Redeemed?

The heart and soul of Exchange Traded Fund is how the ETF units are created. The process of creation and redemption is what makes ETF different from Mutual fund.

ETF is same as mutual fund as one unit of ETF also represents basket of securities. ETFs are also created by large fund companies, known as sponsors, such as Vanguard or Fidelity. These are the same companies that usually deal in mutual funds as well, although some ETF issuers deal with only ETF. The difference between MF and ETF is that while fund companies directly sell the mutual fund units to individual investors, they issue (note - issue not sell) ETF units to large institutional investors or brokers called authorized participants (AP). AP buys all the shares required to create a creation unit and delivers the units to the ETF issuer/sponsor. In return, sponsor issues ETF shares to the AP. After receiving ETF shares, AP sell the shares to individual investors. When AP needs to sell or redeem the shares, the process is reversed. Interesting point is that no buying and selling happens between Sponsor and AP during creation and redemptions. Shares of individual stocks – e.g. all the stocks in S&P 500 - are only swapped (not bought or sold) with creation unit or ETF shares.

How does this swapping help?

It helps individual investor to avoid capital gain because no shares are bought or sold. Avoidance of capital gain events makes ETF more tax efficient than MF. The role of AP in ETF creation/redemption process is the key difference between MF and ETF.

What does Authorized participants gain from participation?

They make money from bid-ask spread for ETF. They are also uniquely positioned to take advantage of arbitrage opportunities. For example, if ETF share price is lower than the NAV, AP can immediately buy ETF shares, redeem the shares for creation unit, and make profit. This will bring the prices back to NAV value. The opportunity helps the AP because they make money from arbitrage. It also helps individual investors because the tracking error is minimized. The process works especially well for the large and popular ETF for which there are multiple AP watching the ETF stock.


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