ETFs rely on a creation/redemption process that is carried out in an OTC primary market between the ETF issuer and authorized participants (a special group of institutional investors).
The creation/redemption mechanism rewards the AP for keeping the price of the ETF in a tight range around the NAV of basket securities. Due to market conditions, the prices of the ETF and basket securities change continuously. The AP monitors both to identify profitable arbitrage opportunities.
An advantage of the ETF creation/redemption process is that the AP absorbs all transaction costs. These costs are then passed on to investors in the secondary market through the bid-ask spread. Therefore, frequent ETF traders bear the cost of their trading activity. Buy-and-hold ETF shareholders are not affected by the negative impact of transaction costs caused by other investors entering and exiting the fund. This makes the ETF structure inherently more fair as compared to mutual funds (where transaction costs affect all investors).
Also, because the creation and redemption process happens in kind, it allows the ETF’s portfolio manager to manage the cost basis of their holdings. The manager can select low-basis holdings for redemptions, to keep capital gains in check, leading to greater tax efficiency.