One unique characteristic of ETFs is the way that shares are created and redeemed.
Before we look at the process for ETFs, let's quickly at what happens with unit trusts and OEICs. If you have money in an OEIC, and you decide to take your money out, the OEIC/unit trust provider has to redeem your units and pay you the value of the units. Those units no longer exist once they've been redeemed. Normally, the provider will have some cash in reserve and can pay you off using that money. But if lots of investors want to take their money out at one time, then the provider may have to sell some of the underlying assets in the fund to generate enough cash to pay everyone off who wants to get out.
If you own shares in an ETF and you want to get your money out, you can sell them on the stock market to another investor. Those shares aren't redeemed, they still exist.
However, shares in ETFs can be redeemed and created by authorised participants or APs.
APs are normally market makers or investment banks and each ETF should have several designated APs. APs have the right to insist an ETF creates new shares in the ETF. To do this, the AP delivers further amounts of the underlying assets held by the ETF, and in return, gets newly created shares in the ETF. So for a FTSE 100 ETF, the AP would provide shares in FTSE 100 companies and then get shares in the ETF in return.
APs can also ask for an ETF to redeem shares in the ETF. If that happens, the AP hands back shares in the ETF to the ETF, and in return gets some of the underlying assets held by the fund, normally company shares.
If the share price of an ETF moves out of line with the value of the underlying assets, the AP can make money via arbitrage. That arbitrage process means an ETF's share price is normally very close to the value of the underlying assets or Net Asset Value (NAV).
This method of creation and redemption is perhaps the biggest difference between ETFs and investment trusts. With investment trusts, shares are only created and redeemed at the discretion of the investment trust's board. There are no authorised participants, so no arbitrage to keep the share price and NAV close together. As a result, investment trusts often a trade at a significant discount to the NAV, this can be 10, 20 or even 30%. And sometimes investment trusts trade at a premium to the NAV.
Significant discounts or premia are much, much rarer when it comes to ETFs.
There's one further point here. Just to make this harder to understand, some ETFs will give cash to APs when they hand in shares in the ETF, instead of shares in the underlying assets.
