ETFs benefit from a unique process called creation/redemption, allowing them to trade on exchanges like individual stocks while maintaining a close correlation to the underlying assets they track. Specifically,
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.
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 and redemption process, the ETF’s portfolio manager typically does not need to buy or sell securities except for rebalancing purposes.
The creation and redemption process may seem complicated, but it is one of the mechanisms that drives ETFs’ potential benefits.
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).
Given that creation/redemption transactions are typically conducted in-kind — meaning securities are exchanged for ETF shares — they are tax exempt, helping to improve the tax efficiency of ETFs.
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 characterized 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 New York Stock Exchange and the NASDAQ are secondary markets.
ETFs can trade above or below their intraday Net Asset Value (iNAV). This discrepancy is known as a premium or discount in the fund.
S&P 500 Index
The S&P 500 Index is composed of 500 selected stocks, all of which are listed on the Exchange, the NYSE or NASDAQ, and spans over 24 separate industry groups. Since 1968, the S&P 500 Index has been a component of the US Commerce Department’s list of Leading Indicators that track key sectors of the US economy. Current information regarding the market value of the S&P 500 Index is available from market information services. The S&P 500 Index is determined, comprised and calculated without regard to the Trust.
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