How ETF Creation and Redemption Works, Step by Step

ETF creation and redemption is the process by which new shares of an exchange-traded fund are issued and existing shares are retired, in large blocks, through a small group of financial firms called authorized participants. It happens in the background, away from ordinary investors, and it is the main reason an ETF’s market price tends to stay close to the value of the securities it holds. Understanding it clears up several common puzzles: why an ETF can grow or shrink without a conventional offering, why large ETFs can trade well even when their holdings are harder to trade, and why some ETFs are more tax efficient than mutual funds.

In brief

• ETF shares are created and redeemed in blocks, often called creation units, only by authorized participants (APs).
• Creation usually works by the AP delivering a basket of securities (and sometimes cash) to the fund in exchange for new ETF shares. Redemption is the reverse.
• Arbitrage by APs and market makers keeps market prices near net asset value (NAV).
• The primary market (fund and AP) is separate from the secondary market (exchange trading among investors).
• The details of each fund’s process are set out in its prospectus and, for most ETFs, in conditions of SEC Rule 6c-11.

Two markets: primary and secondary

When you buy an ETF through your brokerage account, you trade on the secondary market. You buy shares from another investor or a market maker, and the fund itself is not involved. The number of shares outstanding does not change, and the money does not go to the fund.

The primary market is where the fund issues and redeems shares. Only authorized participants, large broker-dealers and financial institutions that have signed agreements with the fund’s distributor, deal with the fund directly. APs typically work in large blocks, which are traditionally called creation units. The size of a creation unit varies by fund and is set out in the fund’s documents.

This two-market design lets ETF shares trade like stocks while the supply of shares expands and contracts with demand.

Who the participants are

• The fund sponsor and adviser. They design the ETF and decide the basket of securities it will accept or deliver.
• The distributor. It processes the paperwork for creations and redemptions and has contracts with APs.
• Authorized participants. These are broker-dealers, often large banks and trading firms, that can create or redeem shares. They are not required to participate on any given day.
• Market makers. They quote buy and sell prices on exchange, earn the spread, and hedge their positions. An AP is often also a market maker, but a market maker does not have to be an AP; it can work with one.
• The custodian. It holds the fund’s assets and settles the delivery of securities and cash.
• Investors. They trade on the secondary market.

How a creation works

In a typical in-kind creation of shares, the steps run as follows.

1. At the end of each day or at the start of the next, the fund publishes the creation basket, a list of securities and any cash amount that an AP must deliver to receive a creation unit. Under the SEC’s ETF rule, most ETFs publish this information, along with portfolio holdings, on their websites each business day.
2. An AP, perhaps responding to strong investor demand that has pushed the ETF’s market price above NAV, assembles the securities in the basket. It may buy them in the market or draw them from inventory.
3. The AP delivers the securities, plus any required cash, to the fund’s custodian and places a creation order with the distributor by a stated cutoff time.
4. The fund issues a creation unit of new ETF shares to the AP.
5. The AP sells the new shares in the secondary market, or holds them as inventory. The extra supply of shares helps push the market price back toward NAV.

Some funds, particularly those holding bonds or less liquid assets, accept cash instead of securities, in whole or in part. In a cash creation, the AP delivers cash and the fund uses it to buy the securities. The AP may pay extra fees to cover the fund’s trading costs, and the process can be less tax efficient than in-kind transactions.

How a redemption works

Redemption mirrors creation. If ETF shares trade at a discount to NAV, an AP can buy ETF shares in the market, gather enough for a creation unit and deliver them to the fund. In exchange, the fund hands over the redemption basket of underlying securities, or cash. The AP can then sell those securities in the market for more than it paid for the ETF shares, and the fund’s share count falls by the number redeemed. The purchases of ETF shares lift the market price toward NAV.

Why this keeps the price close to NAV

The mechanism relies on arbitrage, which means profiting from a small price difference between two equivalent things. If the ETF trades above the value of its basket, an AP can buy the basket, create ETF shares and sell them at the higher price. If it trades below, the AP can buy the ETF shares, redeem them for the basket and sell the securities. The activity itself narrows the difference.

In practice, APs and market makers also consider their costs, including trading fees, financing, the risk that prices move while the transaction settles, and balance sheet constraints. Arbitrage is therefore not free, which is why small premiums and discounts persist, and why they can widen in volatile or illiquid markets. Funds that hold assets traded on markets closed during US hours, such as international stocks, can show larger differences because the underlying prices are stale while the ETF keeps trading.

Why liquidity depends on more than volume

A common misconception is that an ETF’s liquidity is limited to its own trading volume. Because APs can create new shares when demand rises, the amount of ETF shares available is not fixed. A large order in a lightly traded ETF can still be filled at a fair price if market makers can hedge by trading the underlying securities, and, if needed, an AP can create shares. This is why an ETF’s liquidity is linked to the liquidity of its holdings. If the holdings are hard to trade, creation and redemption become costlier and the ETF’s spreads and premiums or discounts tend to be wider.

The tax angle

When an ETF redeems shares in kind, it hands over securities rather than selling them for cash, and the fund generally does not realize a capital gain on the securities delivered. A fund can also use these redemptions to deliver out securities that have large unrealized gains. This is a central reason that many ETFs distribute few capital gains. The effect depends on the fund type and how it uses in-kind transactions, and it is not guaranteed. Consult IRS guidance or a tax professional for your situation.

What the regulation says

SEC Rule 6c-11 under the Investment Company Act sets out conditions under which most ETFs can operate without obtaining individual exemptive relief. Among other things, the rule addresses daily website disclosure of portfolio holdings and the basket used for creations and redemptions, premium and discount information and the use of custom baskets under written policies. Read the rule on the eCFR for the exact conditions, and the fund’s prospectus for how the particular ETF applies them.

A worked example

Take a fictional ETF, Harbor 100 Fund, which tracks an index of 100 stocks. A creation unit is a block of shares the fund defines in its documents; for illustration, say it is 50,000 shares. The fund’s NAV is $40 per share, so a creation unit is worth $2 million.

Strong buying pushes the ETF’s market price to $40.15. An AP sees that a creation unit of shares can be sold for about $2.0075 million while the basket of 100 stocks costs about $2 million. After considering costs, the AP buys the basket, delivers it to the fund, receives 50,000 new shares and sells them on the exchange. As supply rises, the price drifts back toward $40.

Later, selling pressure sends the price to $39.90. The AP now buys 50,000 ETF shares for about $1.995 million, redeems them for the basket worth about $2 million and sells the stocks. The share count falls and the price moves back up. All figures are hypothetical and rounded to illustrate the logic.

Common misconceptions

• Buying ETF shares does not create shares. Only APs create or redeem shares with the fund.
• An ETF’s price is not guaranteed to equal NAV. It usually stays close, but it can diverge.
• Retail investors cannot redeem directly with the fund in most cases.
• Creation and redemption do not remove market risk. The fund’s value still follows its holdings.

FAQ

Can an individual investor create or redeem ETF shares?

Generally no. Creation units are large, and only authorized participants with agreements in place can deal with the fund directly.

What happens if no authorized participant is willing to create or redeem?

The link between market price and NAV can weaken, and premiums or discounts can widen. This has been most noticeable in periods of market stress or for funds holding less liquid assets.

Why do some ETFs use cash instead of securities?

Some holdings, such as certain bonds, are hard to deliver in kind. Cash creations allow the fund to buy the securities itself, though the process can be costlier.

Where can I see the basket and the premium or discount?

On the fund sponsor’s website. Rule 6c-11 requires most ETFs to publish this information.

Does creation and redemption affect the ETF’s expense ratio?

Not directly. APs may pay transaction fees to the fund or its agent, but the expense ratio covers the fund’s annual operating costs.