Creating an ETF has much in common with issuing new stock or inaugurating a mutual fund. But there are some important differences that make this event unique. One of the most relevant is the number of individuals and organizations who play a role in the process.

It includes a sponsoring investment company, an index provider, a custodian, a number of authorized participants, and the Securities and Exchange Commission (SEC) in its role as a securities regulator. Another is the process through which the creation.

etf creation process

The first steps of ETF creation

An ETF sponsor or distributor begins the creation process by identifying the fund’s investment niche and determining its underlying assets, in most cases by selecting an index that’s available to license or collaborating with an index provider on the creation of a new index.

Sponsors generally offer a family of ETFs and have a particular strategy for or philosophy about ETF construction. Some work at building a broad and deep roster of traditional index-based funds. Others take a smaller-scale but less conventional approach, which may include redefining what index means. It’s also the sponsor’s responsibility to register with the SEC to create and market the fund, to select the bank that will act as custodian, and to identify authorized participants who will provide the underlying assets in exchange for shares they can sell on the open market.

Finally, the sponsor must create enough interest in the new ETF so that investors will buy it.

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Being authorized

An authorized participant is a financial institution that is invited to deliver a basket of the securities that underlie the ETF to the sponsor in return for a specific number of ETF shares, often but not always 50 000. That bundle is called a creation unit and those are the shares that are sold to and then traded among investors.

If new security is added to the index, the sponsor asks the authorized participant to deliver shares of the security and returns any securities dropped from the index. That exchange doesn’t affect the value of the ETF shares an investor holds.

The ability to redeem creation units for underlying securities has an intentionally stabilizing effect on the price of ETF shares by ensuring they don’t trade at too large a premium or discount to net asset value (NAV), which sometimes happens with closed-end funds.

If ETF’s shares are selling at a large premium, an authorized participant using a strategy called arbitrage can present the ETF with a basket of the underlying securities, receive a creation unit, sell the corresponding ETF shares at the premium price, and realize a profit. The same strategy works in reverse if an ETF’s shares are selling at a discount to the fund’s NAV.

If the price of an ETF is volatile, as it can be in some cases, investors risk paying more than the NAV to buy and receiving less than the NAV when they sell.

The redemption process

Unlike open-ended mutual funds, ETF sponsors don’t issue new shares in the fund when investors want to buy or redeem shares when investors want to sell. In a reverse of the creation process, however, authorized participants can redeem large blocks of ETF shares in exchange for a basket of securities underlying the fund. To do this they must assemble the number of ETF shares in a creation unit, usually 50 000, and present them to the custodian.

In return for those shares, the authorized participant receives substantially the same basket that it delivered when the shares were created. The difference is that when the sponsor redeems creation units, it typically gives back the securities among its holdings that have the lowest cost basis. That’s acceptable to the authorized participant because the redemption is considered a tax-free exchange, so nothing is owed to the IRS.

education-creation-redemption etf

However, individual investors can benefit from this strategy because if at some point the need to sell underlying securities for any reason, the shares the custodian holds will have a higher average cost basis, minimizing the potential tax impact of any capital gains passed on to shareholders.

Custody arrangements

A custodian’s primary responsibility is relatively simple – keeping the securities underlying the ETF safe and acting as a guarantor against fraud. In the case of stocks or bonds, the custodian holds the electronic record of the securities. With a gold or silver ETF, the custodian has possession of the actual commodity.

The bank’s other primary task is collecting dividends or interest on securities the ETF holds and paying them out in the way that’s appropriate to the particular fund. Some ETFs reinvest these earnings in the fund, others distribute them to shareholders, and still, others offer investors the opportunity to reinvest the money in additional shares.

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