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Untitled Document Five Myths About Creations/Redemptions

The creation/redemption process is the key to ETFs. It is what keeps ETF share prices in line with their net asset values, and what separates ETFs from closed-end funds. But despite its importance, there is a widespread misunderstanding of how the creation/redemption process actually works.

Myth #1: All Creation/Redemption Activity Is In-Kind

Fact: It's true that most creations and redemptions are done in-kind. That is, if authorized participants (APs) want to create new shares of an ETF, they must buy up all the underlying securities in the ETF and deliver them to the ETF issuer (or receive the underlying shares in a redemption). But in certain illiquid segments of the market (commodity, currency, fixed income etc.), some ETFs simply issue shares upon delivery of a stated sum of cash, and then purchase the securities they need on their own.

Myth #2: Creation/Redemption Baskets Must Match The ETF Portfolio

Fact: Most of the time, the creation/redemption basket will match the full ETF portfolio. But there is actually no restriction on what the creation/redemption basket must hold. The list of securities in the basket comes from the ETF issuer each day. It can capture all of an ETF's portfolio, a portion of it or have no bearing on it whatsoever.

Myth #3: Creation/Redemption Activity Takes Place Intraday

Fact: All creation/redemption activity takes place after the close of trading. APs can accommodate intraday demand because ETFs follow a three-day settlement window. They can sell into the intraday market and then hedge their exposure until they backfill supply with the end-of-day creation/redemption process.

Myth #4: The Creation/Redemption Mechanism Always Works

Fact: Not exactly. In less liquid corners of the market, such as fixed income, ETFs have been known to trade at substantial premiums or discounts for long periods of time. The efficiency of the creation/redemption process is tied to the liquidity of the underlying holdings and the liquidity of the ETF itself.

Myth #5: Creation/Redemptions Are Free Money For Authorized Participants

Fact: Hardly. APs must pay a fee every time they execute a creation or redemption, and must pay spreads and take risk when buying and selling the underlying securities.