ETFs benefit from a unique process called creation/redemption. In essence:
Creation involves the buying of all the underlying securities and wrapping them into the exchange traded fund structure
Redemption is the process whereby the ETF is ‘unwrapped’ back into the individual securities
This process sets ETFs apart from other investment vehicles and is the mechanism that underpins many of their benefits, from improved tax efficiency to enhanced liquidity. But there is a lot more to it.
ETF Creation / Redemption Process
The ETF creation and redemption process takes place in the primary market between the ETF issuer and authorised participants (APs). APs are entities chosen by an ETF issuer to undertake the responsibility of obtaining the underlying assets needed to create an ETF. Authorised participants can be large institutional organisations or market makers.
Authorised participants create ETF shares in large increments—known as creation units—by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size. The AP then delivers those securities to the ETF issuer (like us at SPDR ETFs).
In return, the ETF issuer bundles the securities into the ETF wrapper, and delivers the ETF shares to the AP. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange.
When demand increases, more ETF shares can be created using this process. In effect, this allows the liquidity of an ETF’s underlying securities to enhance the liquidity of the ETF itself.
APs can also redeem ETF shares by reversing this process. Large increments of ETF shares—known as redemption units—are collected in the secondary market and then delivered to the ETF issuer in exchange for the underlying securities in the appropriate weighting equaling that redemption unit
As redemption is the opposite process to creation, when demand decreases, the ETF can be dissembled back into single securities.
As a result of the creation/redemption process, the ETF’s portfolio manager typically does not need to buy or sell securities except for rebalancing purposes.
Benefits of the Creation/Redemption Process
The creation and redemption process may seem complicated, but it is one of the mechanisms that drives ETFs’ potential benefits.
Premium/Discount: Because of the creation/redemption process, APs are always closely monitoring the demand for ETFs, and then buying or selling shares in response. By adding or subtracting ETF shares from the market, APs work to keep an ETF’s share price closely aligned with the value of the assets held in the portfolio, mitigating outsized premiums or discounts of the ETF market price to the ETF net asset value (NAV).
Liquidity: In addition, creation/redemption creates two layers of liquidity within an ETF. There’s a layer of available liquidity in the secondary market and a layer of liquidity of the underlying securities. This is why ETF trading volume is not an all-encompassing measure of the fund’s overall liquidity. To understand the full liquidity of an ETF, investors must also consider the liquidity of its underlying securities.
Creation and Redemption Process
The process whereby an ETF issuer takes in and disburses baskets of assets in exchange for the issuance or removal of new ETF shares.
The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterised by a high level of trading activity.
The market where shares of an ETF are created or redeemed.
A market where investors purchase or sell securities or assets from or to other investors, rather than from issuing companies themselves. The Australian Stock Exchange (ASX) and the Chi-X Australia (Chi-X) are secondary markets.
ETFs can trade above or below their intraday indicative Net Asset Value (iNAV). This discrepancy is known as a premium or discount in the fund.
Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL"). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: 612 9240-7600 · Web: www.ssga.com.
State Street Global Advisors, Australia Services Limited (ASL) (AFSL Number 274900, ABN 16 108 671 441) is the issuer of interests and the Responsible Entity for the ETFs which are Australian registered managed investment schemes quoted on the AQUA market of the ASX or listed on the ASX. This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider the product disclosure document, available at www.ssga.com/au, before deciding whether to acquire or continue to hold units in an ETF. This material should not be considered a solicitation to buy or sell a security. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETF's net asset value. ETFs typically invest by sampling an index, holding a range of securities that, in the aggregate, approximates the full index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Holdings and sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. Sector ETF products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. SPDR and Standard & Poor's® S&P® indices are trademarks of Standard & Poor's Financial Services LLC and have been licensed for use by State Street Corporation. The Dow Jones Global Select Real Estate Securities Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by State Street Global Advisors, ASL. MSCI indices, the property of MSCI, Inc. ("MSCI"), and ASX®, a registered trademark of ASX Operations Pty Limited, have been licensed for use by State Street Global Advisors, ASL. SPDR products are not sponsored, endorsed, sold or promoted by any of these entities and none of these entities bear any liability with respect to the ETFs or make any representation, warranty or condition regarding the advisability of buying, selling or holding units in the ETFs issued by State Street Global Advisors, ASL. State Street Global Advisors Trust Company (ARBN 619 273 817) is the trustee of, and the issuer of interests in, the SPDR® S&P 500® ETF Trust, an ETF registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940 and principally listed and traded on NYSE Arca, Inc. under the symbol "SPY". State Street Global Advisors, ASL is the AQUA Product Issuer for the CHESS Depositary Interests (or "CDIs") which have been created over units in SPY and are quoted on the AQUA market of the ASX. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors, ASL's express written consent.