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Appendix A: Understanding ETFs

The Creation/Redemption Mechanism

The key distinguishing feature that separates an ETF from a conventional mutual fund—and the key to its cost advantage—is the “creation/redemption mechanism.”

Imagine an investor who wants to buy $10,000 worth of a particular mutual fund. He submits a buy order through his broker, and $10,000 in cash is transferred from his account to the mutual fund. In return, he receives shares of the mutual fund. The mutual fund doesn’t want to sit on cash, however, so it goes into the market and buys new stocks or bonds.

When the investor wants his money back, the situation is reversed: A sell order is placed, the fund sells some of its stock and bond holdings, and distributes cash to the shareholder.

Each time the fund must buy or sell securities in the market, there are costs: Commissions are paid, bid/ask spreads are negotiated, there is market impact, etc. These costs are borne by the fund itself, and reduce the fund’s returns. To make matters worse, mutual funds regularly carry cash on their balance sheets, as they manage the flow of purchases and redemptions.

In the ETF, these costs are externalized. That is, an ETF is bought and sold just like a stock. If an investor wants to buy $10,000 worth of an ETF, they must purchase that ETF from another shareholder who wants to sell. No money is sent to the investment management company, so no additional securities need to be bought or sold.

If there is significant new demand for an ETF—or significant demand to sell an ETF—new shares of the ETF must either be manufactured or dismantled. If this were not possible, an ETF in high demand would rise in price out of proportion to the actual value of its underlying holdings. This manufacturing and dismantling is done through a process of creation and redemption. This process, however, operates outside of the ETF itself.

Each ETF has one or more institutional investors who act as Authorized Participants (APs) for the fund. If an AP sees strong buy interest in an ETF, they can manufacture new shares in the ETF to meet that demand. To do this, they buy up a basket of all of the underlying securities in the ETF and deliver them to the fund company. Using the SPDR as an example, an AP would buy up all the stocks in the S&P 500 in exactly the right proportion and deliver them to the ETF provider in exchange for shares in the ETF. Typically, these transactions take place in baskets of 50,000 ETF shares.

In the redemption process, the transaction is reversed, and the AP trades 50,000 ETF shares in exchange for a basket of the underlying securities.

The AP will create/redeem shares when the price of the ETF is below/above the price of the underlying securities, creating an arbitrage profit opportunity.

This “in-kind” trade provides the foundation for the ETF’s cost savings because the AP bears all of the costs of buying and selling securities.

Additional Advantages

The creation/redemption mechanism also conveys a sizable tax advantage on ETFs. Because the ETF itself doesn’t typically have to buy or sell securities, conventional equity ETFs rarely accrue capital gains inside the fund, meaning they are more tax efficient for investors. In 2007, just 0.2% of U.S. equity ETFs paid out a capital gains distribution, versus more than 3% of mutual funds.

Additionally, because the holdings of the ETF must be fully transparent for the creation/redemption mechanism to function, ETFs are accepted as trusted tools by advisors and investors. Whereas mutual funds disclose their holdings only once per quarter, ETFs disclose their full holdings daily: What you see is what you get. This transparency has been cited as a key factor for ETFs’ success, especially during market crises, when investors want to be sure there are no surprises in their portfolio.

Other attributes of the ETF process benefit the funds as well. For instance, because ETF investors buy shares on an exchange, and not directly from the ETF company, the ETF doesn’t need a transfer agent to record and manage the transaction, creating additional cost savings.