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.
ETFs grow in size as APs acquire underlying securities and exchange them for shares in the ETF on the primary market, on-selling these shares into the secondary market through the stock exchange.
ETFs help bring asset allocation strategies to life with physically-backed exposures across local and global markets and sectors.
When the authorized participant wants to redeem fund shares of the SPDR ETF, they would follow the same process in reverse. In the secondary market, the AP would gather large increments of fund shares into a redemption unit. Then in the primary market, the AP would deliver the redemption units to State Street (in-kind) in exchange for the underlying securities in the appropriate weightings equaling that redemption unit.
Only authorized participants are able to create or redeem ETF shares in the primary market. Understanding the creation/redemption process is key to understanding the unique structure of ETFs, allowing investors to more efficiently buy and sell ETFs. It is this process that sets ETFs apart from other investment vehicles like traditional mutual funds or stocks.
If exchange traded funds interest you, speak to your advisor or broker to determine if you could benefit from incorporating ETFs into your investment plans. Your advisor can help you analyze your current investments, risk tolerance, tax situation and time horizon, and then recommend strategies to help you achieve your goals.
Passively managed funds invest by sampling the 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. Risk associated with equity investing includes stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. There can be no assurance that a liquid market will be maintained for ETF shares.