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101 Concepts for the Level I Exam

Essential Concept 90: The Creation/Redemption Process – ETFs

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 AP creates new ETF shares by transacting in-kind with the ETF issuer: A pre-specified basket of securities is exchanged for a certain number of shares in the ETF. At the start of every business day, the ETF manager publishes a list of required in-kind securities. This list is called the creation basket.
  • The process also works in reverse: The AP can present the ETF shares to the ETF issuer for redemption and it will receive the basket of underlying securities in return.

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.

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