Bean Musing

ETF: The Mechanism


How the creation-redemption mechanism keeps ETF cost low

This is the second part of the ETF series. Check out the rest:

Unlike stocks that represent the ownership of one company, an ETF has a good deal of underlying securities. Market participants like you and I know that we can buy an ETF share from the exchange (through our broker), but how is that share first created? If the price is supposedly tied to the underlying securities, how does the price of an ETF stay ‘close’ to the underlying price movement of the securities?

The answer is, through ETFs’ unique creation/redemption mechanism.

ETF’s Creation Mechanism - How An ETF Share Is Created

Let’s take a look at how the creation mechanism works.

Behind the scenes, there are 2 participants: the ETF manager (someone like Vanguard or Schwab), and the Authorized Participants (APs). APs are typically large institutions of brokers/dealers, often market makers. They play the role of a middleman between you and the ETF manager, but not in ways that you might think.

It begins with the ETF manager wanting to create an ETF. They list the basket of securities (’creation basket’,’portfolio securities’) with a specific composition that will form the portfolio of the fund each business day, and as and when, the APs will go out and acquire them. Once the purchase is done, the APs exchange the creation basket for ETF shares (’creation units’), which they subsequently sell in the open market.

What happens when the prices of ETF shares and portfolio securities diverge?

It is all fine and dandy when the units are first created. The price of an ETF share is calculated by the Net Asset Value (NAV) divided by the number of ETF shares created. Let’s say the NAV of the creation basket is $100, and there are 100 ETF shares, the price of an ETF share will be $1. You buy and sell with the market participants, with a bid/ask spread, similar to that in stock trading.

As time goes, the prices of the portfolio change. Now the NAV/share is $2, how does the price of an ETF get to $2?

ETF Redemption Mechanism - A Balancing Act

Enters the redemption process.

The APs will buy ETF shares from the open market and return them to the ETF manager in exchange for the underlying securities, which they sell in the open market if it chooses.

Using the same example above, by reducing the number of ETF share units by 50 from 100, the price of each ETF share will be $2.

The reverse is true. If the NAV/share is $0.5, down from the original $1, the APs create an additional 100 ETF shares by buying the portfolio of securities and selling them in the open market, repeating the creation process, and bringing the price of an ETF share to $0.5.

Now, you might be wondering why the APs are willing to do it. Well, it is because there is money to be made. Arbitrage opportunities exist between the price of the ETF share and the price of the portfolio securities. If the ETF share is trading at a premium to the NAV, the APs can short the ETF shares while buying up the relatively underpriced portfolio securities, earning a risk-free profit in the meantime. In the case of an ETF share discount, the APs then buy the ETF shares and sell the overpriced portfolio securities.

ETFs vs Mutual Funds: The Mechanism Differences

The presence of APs is one that distinguishes ETFs from mutual funds. APs absorbs all the costs related to the transaction of securities, passes them through the bid/ask spread to ETF buyers and sellers, and keeps the expense ratio of the ETF low. This makes the system fairer to the buy-and-hold investors as the transaction cost is passed on to active traders. In the case of mutual funds, a buy-and-hold investor would be penalized by the transaction costs incurred by other participants’ activities of entering and exiting, as the transaction cost is shared among all unitholders.

You might ask, why can’t a mutual fund do the same thing as an ETF? Well, one, a mutual fund unit is not listed on the exchange. It doesn’t have the same liquidity as an ETF. Furthermore, the price of a mutual fund is only determined once a day, based on the closing NAV - a market maker is unlikely to participate in such an illiquid transaction. There is also the issue where mutual funds keep a large holding of cash in case of large redemption requests from investors, whereas in the case of an ETF, it is a share-for-share swap.

Another point people bring up is tax efficiency. Because of the creation/redemption mechanism, capital gain simply does not happen, as the transaction does not involve selling, but swapping of shares. Even in the case where the APs need to sell the securities in the open market, the ETF manager can deliver the tax lot with the highest cost basis to minimize capital gains.

For that of a mutual fund, there is constant selling and buying activity, and the capital gain taxes are shared among the participants, even if one’s holding is at a loss. The ideology of a mutual fund is that of pooled assets and perhaps shared camaraderie, but they probably miss out on how the misery is shared and made worse for some.