ETFs benefit from a unique process called creation / redemption. In essence:
Creation involves the buying of all the underlying securities and wrapping them into the exchange traded fund structure
Redemption is the process whereby the ETF is ‘unwrapped’ back into the individual securities
This process sets ETFs apart from other investment vehicles and is the mechanism that underpins many of their benefits, from improved price discovery to enhanced liquidity. But there is a lot more to it.
ETF Creation / Redemption Process
The ETF creation and redemption process takes place in the primary market between the ETF issuer and participating dealers (PDs). PDs are entities chosen by an ETF issuer to undertake the responsibility of creating ETF units. Participating dealers can be large institutional organisations or market makers.
Participating dealers create ETF shares in large increments—known as creation units—by delivering cash to the ETF issuer. The ETF issuer utilizes the cash to assemble the underlying securities of the fund in their appropriate weightings to reach creation unit size.
The ETF issuer bundles the securities into the ETF wrapper, and delivers the ETF shares to the PD. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange.
When demand increases, more ETF shares can be created using this process. In effect, this allows the liquidity of an ETF’s underlying securities to enhance the liquidity of the ETF itself.
PDs can also redeem ETF shares by reversing this process. Large increments of ETF shares—known as redemption units—are collected in the secondary market and then delivered to the ETF issuer in exchange for the cash raised from selling the underlying securities in the appropriate weighting equaling that redemption unit.
Benefits of the Creation / Redemption Process
The creation and redemption process may seem complicated, but it is one of the mechanisms that drives ETFs’ potential benefits.
Premium / Discount: Because of the creation / redemption process, PDs are always closely monitoring the demand for ETFs, and then buying or selling shares in response. By adding or subtracting ETF shares from the market, PDs work to keep an ETF’s share price closely aligned with the value of the assets held in the portfolio, mitigating outsized premiums or discounts of the ETF market price to the ETF net asset value (NAV).
Liquidity: In addition, creation / redemption creates two layers of liquidity within an ETF. There’s a layer of available liquidity in the secondary market and a layer of liquidity of the underlying securities. This is why ETF trading volume is not an all-encompassing measure of the fund’s overall liquidity. To understand the full liquidity of an ETF, investors must also consider the liquidity of its underlying securities.
Glossary / Definitions
Creation and Redemption Process The process whereby an ETF issuer takes in and disburses cash in exchange for the issuance or removal of new ETF shares.
Liquidity The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterised by a high level of trading activity.
Primary Market The market where shares of an ETF are created or redeemed.
Secondary Market A market where investors purchase or sell securities or assets from or to other investors, rather than from issuing companies themselves. The Hong Kong Stock Exchange (HKEX) is one example of a secondary market.
Premium / Discount ETFs can trade above or below their intraday indicative Net Asset Value (iNAV). This discrepancy is known as a premium or discount in the fund.
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