Creation and redemption: the unique thing about ETFs

The creation and redemption process is at the heart of what makes ETFs work. 

Exchange-traded funds (ETFs) are a sort of hybrid fund. First, as the exchange-traded in their name suggests, they are able to be bought and sold throughout the day on a stock exchange. Much like with an individual company share or an investment trust, an investor can buy or sell their shares in an ETF at any point while markets are open.

However, unlike with investment trusts, ETFs do not have a “fixed pool” of capital. If enough new investors want to buy into an ETF, the ETF will see the amount of money it manages grow. In this sense, an ETF also resembles an open-ended fund structure. Of course, traditional open-ended fund structures are unable to be traded on stock market throughout the day.

ETFs, therefore, are a unique and hybrid type of fund vehicle. The process that allows this fund structure to do this is known as the creation and redemption process and is at the heart of what makes ETFs work.

Buying on the secondary market

To start, lets imagine you want to invest in iShares Global Clean Energy ETF (LSE:INRG), one of the most popular ETFs right now. To invest in this ETF you will place an order on your interactive investor account. Simply put, the platform will arrange for you to buy shares in the ETF from another investor looking to sell. Once the order is carried out, you will have shares of the ETF in your portfolio.

This whole process is called buying shares on the “secondary market”, meaning you bought from another investor. You did not buy them from the ETF issuer (iShares, in this case) or have any dealings with them.

If you change your mind on the ETF and want to sell, you will place a sell order with your interactive investor account and another investor in the market will buy your shares in the ETF. On the surface this is the same if you have bought shares in an investment trust.

Price and net asset value

However, unlike with an investment trust, ETFs are designed to not allow a large difference between the share price of the ETF and its underlying assets to emerge. It is also designed, to allow for the pool of capital the fund manages to increase in size as investor interest grows.

To understand this, it perhaps worth starting with a brief overview of investment trusts.

When you buy shares in an investment trust, the price of the shares may be worth either more or less than the actual value of the underlying holdings i.e. the companies the trust has in its portfolio.

For the sake of argument, imagine an investment trust has £100 worth of assets. This is its net asset value. Now imagine the trust has 20 shares in existence, trading on the market. If those shares are trading at £5 each, it could be said they are trading at “fair value”. The value of the underlying holdings per share corresponds with the price of the share.

Of course, the market being what it is, there is often divergence. If investors become bullish on the trust, the shares could start trading at £6 each. This would mean the trust is trading at a premium of 20%. The market cap of 20 shares would be £120. This market cap would be 20% higher than the £100 net asset value. Likewise, if the share price falls to £4 (and net asset value stays the same), the shares will be trading at discount. Investor buying or selling does not directly influence the amount of money being managed by the trust.

It is worth pointing out, though, that investment trusts have the ability to issue new shares to broaden the investor base. In the vast majority of cases new shares are only issued when a trust is persistently trading on a premium and therefore in high demand with investors.

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So what does this have to do with ETFs? Similar to trusts, an ETF also has a share price and net asset value that can, at times, diverge. However, the key difference with ETFs is that they are designed to minimise the difference between share price and net asset value, known as the creation/redemption process. This is the revolutionary thing about ETFs. 

Authorised participants

At the heart of this process is a special group of professional investors called “authorised participants” (AP). These professional investors have special authorisation to create or redeem (destroy) shares in a specific ETF, hence the term “creation/redemption process”. 

Let’s return to the iShares Global Clean Energy ETF. Let’s imagine it has become very popular, meaning a surge of new investors are trying to buy shares in the ETF. There are now more buyers than sellers. As a result, the share price of the ETF goes up more than the underlying value (or net asset value) per share.

If this happened to an investment trust, the trust’s shares would be said to be trading at a premium. Nothing much would happen at first, as it is generally accepted that this is how investment trust’s work – sometimes they trade at a premium (or a discount).

However, in the case of an ETF, this divergence in price and net asset value should not last long, thanks to the work of the APs. The divergence is a so-called arbitrage opportunity for the APs.

Say the shares in the iShares Global Clean Energy ETF are trading at £10.03 each. However, the fair value of each share, based on the underlying value of its holdings, is £10. That means the shares are trading at a 0.3% premium, or 3 pence per share.

The AP will go into the market and buy the basket of stocks that the ETF tracks, in proportion to their weighting, per the index. In the case of the iShares Global Clean Energy ETF, this is the S&P Global Clean Energy Index.

The AP will then go to the ETF issuer, in this case iShares, and trade these underlying basket of shares for shares in the ETF. The AP will then take these ETF shares and sell them on the open market.

In doing this, the AP will be able to pocket a profit of 3 pence per share. Remember, the ETF’s shares are trading at a 0.3% premium compared to the underlying assets of the ETF. So, when the AP trades underlying shares for ETF shares, they are getting ETF shares that can be sold at a slightly higher value, creating the profit, or arbitrage, opportunity.

Crucially, however, this whole process does two things. First, it puts downward pressure on the ETFs share price, hopefully pushing it closer towards the net asset value per share. Second, it puts upwards pressure on the underlying shares in the ETF, as the whole process has seen APs purchase these shares in the market. This process will be repeated until price and net asset value converge. Once they do, the arbitrage gap disappears.  

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This process also means that the increased investor demand for shares in the ETF results in the ETF managing a larger amount of capital. Hence, an ETF is not a closed-end structure like an investment trust. More investors buying means the ETF grows, albeit via the work of APs trying to profit from arbitrage.

If the ETF becomes unpopular, the opposite process takes place. Say investors start selling iShares Global Clean Energy. This will potentially drive the price of the ETFs shares below fair value. So the ETF’s shares start trading at £9.97. This would mean the ETF is trading at a 0.3% discount, or 3p per share.

So once again, in step APs. The AP will buy the ETF shares trading at a discount - £9.97 per share. The AP will then take these shares to the ETF issuer and “redeem” them. This means that the shares are cancelled and in return the AP receives the basket of underlying stocks, at net asset value per share. These shares can then be sold.

So, this should give the AP a profit of 3 pence per share when they sell the underlying stocks on the open market. Like with the creation process, this will close the arbitrage gap as the APs buys ETF shares, raising the price, and sells the underlying holdings, pushing down their price.

It also means that investors selling shares in the ETF indirectly cause the amount of assets in the ETF to decline.