ETF shares are created and redeemed by authorized participants (APs).
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ETFs grow as primary market capital is provided through authorized participants, and are then released as shares to trade on the secondary market.
Exchange traded funds (ETFs) in the market place today cover a wide variety of asset classes. There are ETFs that track broad-market indexes, specific sectors, as well as fixed income, commodity, currency and leveraged products.
In the simplest terms, ETFs are a collection or “basket” of securities that typically track a specific market index. As such, ETFs have characteristics of both stocks and mutual funds.
Similar to a stock, they trade on the exchange.
Like indexed mutual funds, ETFs are transparent with their expenses and holdings.
While there are some similarities, the main difference between ETFs and other investment vehicles, like traditional mutual funds or stocks, is the process through which fund shares are created and redeemed. This is called the creation/redemption process and takes place in the primary market between the fund and authorized participants (APs).
The creation of shares happens when new investments are made to the ETF, and the ETF issues shares that will trade on the exchange with existing shares.
The redemption of shares is when shares are exchanged for their cash value with the ETF.
APs are registered, self-clearing broker dealers who meet certain criteria and sign a participant agreement with a particular ETF sponsor or distributor to become authorized participants of the fund. APs are highly scrutinized for their integrity and operational competence; they are the only parties who transact directly with the fund.
APs create fund 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 (typically 100,000 fund shares) and then delivering those securities to the fund in-kind. In return, the AP receives fund shares which are then introduced to the secondary market where they are traded between buyers and sellers through the exchange. As a result of the creation/redemption process, the ETF’s portfolio manager typically does not have to buy or sell securities except for rebalancing purposes.
APs also have the ability to redeem fund shares through the same process in reverse. Large increments of fund shares—known as redemption units—are collected in the secondary market and then delivered to the fund in-kind in exchange for the underlying securities in the appropriate weighting equaling that redemption unit (again, typically 100,000 shares).
To help illustrate this process, let’s walk through an example:
The Creation and Redemption of SPDR ETF Shares: Suppose an authorized participant wants to create shares in one of State Street‘s SPDR ETFs. First, the AP would reference a list of the exact securities and their weightings within the fund. The list is provided daily by the ETF fund sponsor. The AP would gather those same securities in their appropriate weightings into a creation unit. Next, the AP would transfer the creation unit in-kind to State Street in exchange for ETF shares . To complete the creation process, the AP would introduce these newly created SPDR ETF shares into the secondary market where they would be traded between buyers and sellers through the exchange.