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 sponsor and authorized participants (APs). APs are US registered, self-clearing broker-dealers, who regulate the supply of ETF shares in the secondary market.
Authorized 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, which is typically 50,000 ETF shares. The AP then delivers those securities to the ETF sponsor (like us at SPDR ETFs).
In return, the ETF sponsor 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 sponsor in exchange for the underlying securities in the appropriate weighting equaling that redemption unit (again, typically 50,000 shares).
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.