The key to understanding any concept is the often-neglected details. Thus, knowing the ETF creation and redemption process becomes of paramount importance.
This process tells us how exchange-traded funds gain exposure to the market and the secret behind their affordability.
Let’s have a look at the ETF creation and redemption process
ETFs creation process
The process begins with the ETF manager filing a plan with the competent authority.
For instance, the manager will file a project with the Securities and Exchange Commission (SEC) if in the USA or the Securities and Exchange Board of India (SEBI) in India.
Once the approvals are in place, the ETF manager, often called a sponsor, agrees with the Authorized Party (AP). In some cases, the sponsor and the AP are the same entity.
Step 1:
The creation of exchange-traded funds starts with a party called an Authorized Participant (AP). An Authorized Participant can be a professional, financial institution, market maker, or a person with tons of money
Step 2:
Now, it is the job of this Authorized Participant to get hold of all the assets or securities that the ETF wants to hold.
For instance, if the ETF tracks the Sensex, the Authorized Participant buys some quantity of all the constituent shares of the Sensex. Similarly, if the ETF tracks the Dow Jones Industrial Average, the AP will buy some shares of all the 30 companies that are a part of the index.
Step 3:
After that, the Authorized Participant will then deliver these to the Exchange Traded Fund. The Authorized Participant will get a block of ETF shares of equal value as payment for his services.
Usually, a block consists of 50,000 shares. The swap is a one-on-one fair value based on the NAV of the ETF share and not the market value.
Both benefit from this transaction; the AP gets the ETF shares that he can resell for profit, and the ETF provider gets the stocks it needs to track.
Step 4:
The ETF shares received by the AP are listed in the secondary market and traded just like standard stocks.
ETFs redemption process
The redemption process can be associated with two people
- The Authorized Participant
- Retail investor.
For the Authorized Participant, it will be as under:
Step 1:
The Authorized Participant buys the shares trading on the stock market.
Step 2:
The Authorized Participant will deliver the shares to the fund.
Step 3:
The ETF will give the underlying securities back to the Authorized Participant.
Step 4:
The Authorized Participant will then sell these securities in the stock market.
An investor can sell off his Exchange Traded Fund in two ways-
- Sell openly in the stock market, the most chosen one.
- Gather enough ETF shares to make a creation unit (mostly 50,000 units) and sell it back to the fund. Generally, only Institutional investors have this option open due to its higher costs. When the fund gets this creation unit, it is destroyed, and the underlying security goes back to the redeemer.
The study of this creation and redemption is crucial because it keeps the share price of the ETF near its underlying NAV, i.e., the Net Asset Value.
Net Asset Value represents the fund’s per share/unit price on a specific date or time.
For instance, if the ETF price falls below the NAV, the AP will interfere in the open market and buy up the ETF shares, raising its price and bringing it back to the level of its NAV.
Similarly, if the ETF price increases well above its NAV, the AP will intervene and buy the underlying securities and sell off new ETF shares – bringing the price of the ETF shares back to its NAV value.
This arbitrage process is not perfect, but it helps contain the volatility of the ETF share price quite effectively.
FAQs
How is an ETF created?
Ans. When an ETF is created, a financial organization known as a sponsor purchases a selection of equities to represent the ETF’s holdings. The sponsor issues ETF shares that reflect the value of the holding’s portfolio once these shares are placed in a trust.
What is an example of ETF creation redemption?
Ans. The AP could sell the shares it was given when the ETF was created and earn a spread between the cost of the assets it purchased for the ETF issuer and the selling price from the ETF shares if the ETF is in high demand and trades at a premium.
What is the creation redemption process of ETFs and the function of authorized participants?
Ans. ETF shares are created through a process known as creation and redemption, which takes place in the primary market at the fund level. It permits authorized participants (APs), like licensed market makers, to trade a predetermined basket of securities, including cash, for a specific number of ETF shares.
