Introduction

The creation-redemption process is the mechanism that sets ETFs apart from other investment vehicles and is the key driver behind many of the wrapper’s benefits.

ETF creations and redemptions occur in the primary market where an authorised participant (AP) is responsible for ensuring an ETF trades at fair value, usually in line with its net asset value (NAV).

Premiums and discounts

Because ETFs trade on exchange like a stock, its price can be driven by supply and demand. Therefore, if there is strong demand, an ETF’s price may rise above the value of its underlying basket of securities and vice-versa if there is selling pressure.

If the ETF is trading at a higher price than its NAV – known as a premium – an AP can buy the underlying securities of an ETF – a creation basket – and sell the ETF shares to make a small profit, a process that pushes the ETF’s share price back towards fair value.

When an ETF is trading at a discount to NAV, an AP will reverse this process by buying the ETF shares on exchange and then redeeming them for the underlying securities.

Through the creation-redemption process, APs ensure ETFs trade in line with the value of the underlying securities.

The mechanism and the role of APs is the key difference between ETFs and close-ended funds which do not have actors involved in creating and redeeming shares.

This means close-ended funds such as investment trusts can trade at huge premiums and discounts depending on demand for a particular strategy.

However, in periods when the primary market cannot be accessed by APs, ETFs effectively begin trading like close-ended funds because APs are unable to create ETF shares from the underlying market.

This occurred when the Egypt stock market closed during the Arab Spring in 2011. The Market Vectors Egypt ETF (EGPT), which was the only way to access the Egyptian market, started trading at a significant premium to NAV as demand for Egypt exposure was high. When the market re-opened, the ETF moved back in line with its NAV.

ETFs vs mutual funds

Furthermore, the creation-redemption mechanism is what separates ETFs from mutual funds. While ETFs can trade at high premiums and discounts during periods of illiquidity in the underlying market, mutual funds can be forced to gate if there is a run on the fund – see the recent Neil Woodford and UK property sagas.

Overall, the creation-redemption process enables ETFs to trade at fair value instead of swinging to high premiums and discounts. While the mechanism is not perfect, it serves a crucial role in delivering the key benefits of the wrapper.