Creation and Redemption of ETF Shares

ETF shares are created and redeemed by an entity known as an “authorized participant,” or “AP,” which is typically a large broker dealer. Each business day, the ETF publishes a “creation basket”—a list of names and quantities of securities or other assets held by the ETF. To create ETF shares, an AP provides the creation basket to the ETF, and receives in return a “creation unit,” a large block of ETF shares (typically 50,000 shares). Under certain circumstances, the AP may provide cash in lieu of some or all of the securities in the creation basket, along with a transaction fee to offset the cost to the ETF of acquiring the securities. Upon receiving the ETF shares, the AP may sell some or all of them in the secondary market.

A creation unit is liquidated when an AP returns the specified number of shares in the creation unit to the ETF, in exchange for the daily “redemption basket” (a set of specific securities and other assets contained within the ETF’s portfolio), cash, or both. The composition of the redemption basket typically mirrors that of the creation basket. If the AP receives cash in lieu of securities, it will pay a transaction fee to offset the cost to the ETF of liquidating the securities.

The creation and redemption mechanisms help ETF shares to trade at a price close to the market value of their underlying assets. When ETF shares begin to trade at a price that is higher than the market value of their underlying assets (at a “premium”), APs may find it profitable to create ETF shares by buying the underlying securities and exchanging them for ETF shares, and then sell those shares into the market. Similarly, when ETF shares begin to trade at a price lower than the market value of their underlying assets (at a “discount”), APs may find it profitable to buy ETF shares in the secondary market and redeem them to the ETF in exchange for the underlying securities. These actions by APs, commonly described as “arbitrage opportunities,” help to keep the market-determined price of an ETF’s shares close to the market value of their underlying assets.

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