Creation & Redemption Process
Like stocks, ETFs trade throughout the day in the secondary market.
In the primary market, ETF sponsors work with authorized participants (APs) to create and redeem ETF shares. This process allows underlying securities to be exchanged as fund assets grow, shrink, or rebalance, which may help limit the realization of capital gains within the fund.
Authorized Participant
Delivers or receives a basket of securities in exchange for ETF shares.
Creation / Redemption
Shares are created when demand rises and redeemed when demand contracts.
Market Trading
ETF shares then trade in the secondary market like stocks.
The authorized participant assembles the required basket of securities.
The basket is delivered to the ETF issuer in exchange for newly created ETF shares.
New shares are issued and can then trade on the exchange in the secondary market.
The authorized participant returns ETF shares to the issuer for redemption.
The issuer removes those shares from circulation through the redemption process.
The authorized participant receives a basket of securities of equal value in exchange.
How ETF shares are created
When demand for an ETF increases, authorized participants can create new ETF shares by delivering a basket of underlying securities to the ETF sponsor in exchange for ETF shares of equal value.
- Helps add inventory when demand rises
- Keeps the ETF structure flexible and scalable
- Supports efficient trading in the secondary market
How ETF shares are redeemed
When market supply needs to contract, authorized participants can return ETF shares to the issuer and receive a basket of underlying securities of equal value in exchange.
- Helps reduce inventory when supply is high
- Removes shares from circulation through redemption
- Supports the ETF's ongoing market efficiency
The creation and redemption process allows Authorized Participants and ETF sponsors to exchange baskets of securities and ETF shares of equal value. This structure is a key feature that supports ETF efficiency.
In-Kind Transfer of Securities
When an Authorized Participant (AP) creates or redeems shares with the ETF sponsor, they swap ETF shares for shares of the underlying securities, or vice versa. The AP and ETF sponsor are essentially exchanging baskets of equal value with one another.
Offset Capital Gains and Losses
There are many opportunities for the fund manager to offset capital gains and losses during the creation and redemption process, including during a fund rebalance. This can help support the tax efficiency often associated with ETFs.
A large financial institution that enters into a legal contract with an ETF distributor to create and redeem shares of the fund.
A financial firm that issues, manages, and markets an exchange-traded fund.
Liquidity
Liquidity refers to the ability and ease at which investors can buy or sell assets at fair prices.
ETF liquidity is generally driven by the liquidity of the underlying securities it holds.
Unlike individual stocks, ETF liquidity is not driven primarily by average daily trading volume.
If the underlying securities within an ETF are liquid, the ETF can have a potential for greater liquidity mirroring its underlying securities, regardless of the ETF’s average daily trading volume.
Unlike mutual funds, ETFs can be traded intraday and are priced continuously throughout the day.
Efficient Trading
Volume does not equal liquidity
The liquidity of an ETF is generally driven by the liquidity of the underlying securities it holds, rather than its own average daily trading volume.
On the exchange
Much like stocks, secondary market liquidity is established by matching buy and sell orders for ETFs on an exchange. The interaction between buyers and sellers helps facilitate liquidity in the secondary market.
Market maker activity
Market makers are high-volume traders that “make a market” for securities by standing ready to buy or sell. They provide liquidity and help ensure investors can trade quickly and at fair prices. Market makers buy securities from sellers and sell securities to buyers, generally from their own inventory.
Unit creation based on underlying securities
Because ETFs are open-ended funds, Authorized Participants can create or redeem shares based on supply and demand. This helps keep ETF prices aligned with the value of the underlying securities, differing from market makers who provide continuous buy and sell quotes to keep ETF trading liquid.
Trading Tips
Using Limit Orders and ETF Liquidity
Understanding order types and ETF pricing may help investors trade more efficiently. ETF liquidity is generally driven by the liquidity of the underlying securities, rather than average daily trading volume alone.
1. Use Limit Orders
In order to know exactly what price you will get, place a limit order.
What happens when you place a limit order to buy 5,000 shares at $20.65?
Caution: Watch your order. It is possible the market will move away from your order and it will not be filled. If that happens, readjust your limit order.
2. Do Not Use Market Orders
To reduce potential poor execution, do not use market orders. WHY NOT: Contrasting the previous example, what happens when a market order to buy is placed at 5,000 shares?
Trading Volume DOES NOT Equal Liquidity
Unlike stocks, an ETF’s trading volume does not equal its liquidity. This is due to how ETFs are traded. With ETFs, new shares can be created and existing shares redeemed at any time based on investor demand. The creation and redemption process works by evaluating the liquidity of an ETF’s underlying portfolio of securities. If the underlying stocks are liquid, the ETF will have a potential for greater liquidity, mirroring its underlying securities.
3. Place Your Limit Order Close to the IIV/IOPV
The bid and ask will be close to the IIV (Intraday Indicative Value)/IOPV (Indicative Optimized Portfolio Value). If the IIV/IOPV deviates too far from the bid/ask, the market makers will arbitrage (simultaneously buy and sell the ETF shares for a profit). Check the current IIV/IOPV using Google.com, Yahoo.com, Bloomberg, Reuters, etc. Place your bid close to the IIV/IOPV.
4. Large Orders Do Not Affect the IIV/IOPV
Since share price is based on the underlying value of the securities that make up an index—not supply and demand—a large order will not “move this market” (except in cases where the underlying securities are thinly traded). Historically, large market orders generally receive the worst execution prices, therefore, remember Tip #1: Use Limit Orders. Contact your trade desk for further explanation.
5. Redeem Shares at Any Time for a Fair Price
The market maker will always create or redeem shares based on the value of the underlying securities plus a spread (bid/ask). Using limit orders will greatly improve your overall execution prices. The IIV/IOPV is NOT determined by buys and sells.
6. IOPV Can Be Inaccurate for ETFs That Hold Foreign Securities
Foreign securities in some ETFs may be traded on exchanges which are closed during US market hours.
Limit Order: An order placed to buy or sell a set number of shares at a specified price or better.
Market Order: An order to buy or sell a stock immediately at the best available current price.
Bid: The price a buyer is willing to pay for a security.
Ask: The price a seller is willing to accept for a security.
Bid-Ask Spread: The amount by which the ask price exceeds the bid.
Intraday Indicative Value (IIV)/Indicative Optimized Portfolio Value (IOPV): A real-time estimate of the ETF’s fair value, based on the underlying holdings that make up an index.
ETF Creation & Redemption Video
Sean O'Hara, President of Pacer ETFs Distributors, discusses the key differences between ETFs and mutual funds and how the creation/redemption process can help drive ETF efficiency.
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