What is an ETF?
Exchange-traded funds (ETFs) are investment vehicles that have many attributes of mutual funds but trade throughout the day on an exchange like a stock. ETFs come in a variety of styles including passive or index ETFs, which typically aim to closely track their underlying index, and actively managed ETFs, which are typically managed with the objective of providing above-benchmark returns or to objectives such as income or total return. ETFs offer investors many benefits such as intraday liquidity and pricing, trading flexibility, transparency of holdings and potential tax advantages. Because ETFs trade like stocks, investors may be able to buy them on margin or sell them short, and have the added flexibility to use limit or stop-loss orders and, in many cases, use options strategies.
How do ETFs work?
Most ETFs are open-end investment companies that are registered under the Investment Company Act of 1940 and are subject to essentially the same rules and regulations as traditional mutual funds. They are investment vehicles in which investors own a proportional share of the pooled underlying securities. Unlike mutual funds, which issue shares in the fund directly to investors that can be redeemed directly back to the fund at the net asset value, or NAV, determined at the end of each trading day, ETFs trade throughout the day on exchanges at current market prices. ETF shares are issued or redeemed through an authorized participant in what is called a “creation or redemption.”
What is an ETF creation or redemption?
An ETF creation is the process by which authorized participants (APs) – self-clearing broker-dealers who have signed an agreement with the ETF manager – deliver the securities or cash that constitute the creation basket of the ETF to the fund manager in exchange for units of the ETF. Conversely, an ETF redemption is when an AP delivers shares of the ETF to the fund manager in exchange for the individual securities or cash constituting the fund redemption basket. A creation or redemption basket contains the securities the ETF manager accepts or delivers in exchange for shares of the ETFs. Through creations, the net assets under management (AUM) of the ETF increase in response to demand for the shares, and through redemptions, AUM decline as supply outstrips demand. Creation and redemption transactions only occur at the NAV of the fund and can only be implemented in block unit sizes, which typically range from 50,000 to 100,000 ETF shares. Typically, an ETF manager has several APs that can create or redeem its ETFs.