( ETF ) Creation and Redemption Process

ETFs have a unique so-called creation / redemption mechanism which allows professional market participants to exchange baskets of shares with the same composition at any time for ETFs (and vice versa) with the fund. This ability to continually create or redeem shares helps keep an ETF’s market price in line with its underlying net asset value. A key feature that distinguishes ETFs is that the shares are created by ‘authorised participants’ or creation/redemption brokers in block-size ‘creation units’. The creator deposits into the applicable fund a portfolio of stocks closely approximating the holdings of the index in exchange for an institutional block of ETF shares (usually 50,000). Similarly, they can only be redeemed in redemption units, mainly ‘in-kind’ for a portfolio of stocks held by the fund. The redemption and creation processes are very similar. However, a key benefit is that the in-kind distribution of securities does not create a tax-event, which could occur if the fund sold securities and delivered cash. This is a special advantage of an index-linked ETF versus an open-ended indexed mutual fund, which would have to sell securities to meet cash redemptions.
The issuers and primary traders of index funds operate following the creation – redemption model. In order to track the underlying index, the Designated Sponsors set up a basket of stocks with a composition that mirrors the fund portfolio 1:1. They receive unit shares from the issuers, to the value of the basket, which can subsequently be sold on the market (creation of fund shares). They can also redeem unit shares in the fund, receiving stocks from the issuer in exchange (redemption).