🔄 Creation & Redemption

If you’ve traded ETFs, you’ve probably wondered: when I buy $10,000 of SPY, does someone actually go purchase all 500 stocks in the S&P 500? And when I sell, does someone sell them?

The short answer: no. Your purchase doesn’t trigger any buying of underlying securities. The mechanism is more elegant than that — and understanding it explains why ETFs trade so efficiently.

How is buying an ETF different from buying a mutual fund?

This distinction is fundamental to understanding how ETFs work.

Mutual funds: direct transactions with the fund

When you buy a mutual fund:

1. You send money to the fund company
2. The fund manager takes your cash and buys securities
3. New shares are created for you at end-of-day NAV
4. When you sell, the reverse happens — the fund sells securities to generate cash for you

Every purchase and sale directly affects the fund’s portfolio. The fund manager must constantly buy and sell to accommodate investor flows.

ETFs: trading with other investors

When you buy an ETF:

1. You buy existing shares from another investor on the exchange
2. The transaction happens at the current market price (not NAV)
3. The ETF’s portfolio is completely unaffected
4. No securities are bought or sold inside the fund

This is identical to buying stock in Apple or any other company. You’re buying from a seller, not from the company itself.

Then how do new ETF shares get created?

This is where Authorized Participants (APs) enter the picture. They’re the bridge between the secondary market (where you trade) and the primary market (where shares are created and destroyed).

What is an Authorized Participant?

An Authorized Participant is a large institutional broker-dealer with a special agreement allowing them to create and redeem ETF shares directly with the fund sponsor.

Per SEC Rule 6c-11:

“Authorized participant means a member or participant of a clearing agency registered with the Commission, which has a written agreement with the exchange-traded fund or one of its service providers that allows the authorized participant to place orders for the purchase and redemption of creation units.”

In practice, APs are firms like Goldman Sachs, Jane Street, Citadel Securities, and other major market makers. Most large ETFs have multiple APs competing to provide liquidity.

The creation process

When sustained buying pressure pushes an ETF’s price above its Net Asset Value (NAV), an arbitrage opportunity emerges. Here’s how an AP exploits it:

According to State Street Global Advisors:

“Authorized participants create ETF shares in large increments — known as creation units — by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size, which is typically 50,000 ETF shares.”

The redemption process

When selling pressure pushes an ETF’s price below NAV, APs do the reverse:

What does “in-kind” mean?

Most ETF creation and redemption happens “in-kind” — meaning securities are exchanged for ETF shares rather than cash.

The in-kind mechanism is a major reason ETFs are more tax-efficient than mutual funds. When an AP redeems shares, the ETF can hand over appreciated securities, effectively transferring the embedded capital gains to the AP rather than realizing them inside the fund.

How does arbitrage keep prices aligned with NAV?

The creation/redemption mechanism creates a powerful arbitrage loop that keeps ETF prices close to fair value.

When the ETF trades at a premium (price > NAV)

When the ETF trades at a discount (price < NAV)

This arbitrage happens continuously throughout the trading day. For liquid ETFs like SPY, the premium or discount rarely exceeds a few basis points.

Why doesn’t the ETF manager need to trade?

This is the elegant part of the design. From State Street Global Advisors:

“As a result of the creation and redemption process, the ETF’s portfolio manager typically does not need to buy or sell securities except for rebalancing purposes.”

The ETF is essentially a wrapper around a portfolio of securities. When the wrapper gets too expensive (premium), APs make more of them. When it gets too cheap (discount), APs unwrap them. The underlying portfolio remains largely undisturbed.

This differs dramatically from mutual funds, where the portfolio manager must constantly trade to accommodate cash flows from investors buying and selling.

What happens during market stress?

The creation/redemption mechanism generally works well, but it can be tested during extreme volatility.

Liquidity mismatches

Some ETFs hold assets that are less liquid than the ETF itself:

During March 2020, some fixed-income ETFs traded at significant discounts to their NAV because the underlying bonds were difficult to trade. APs widened their spreads to account for the execution risk.

When arbitrage breaks down

Arbitrage can become less effective when:

• Underlying securities stop trading (international ETFs during home-market close)
• Extreme volatility makes it risky to hold positions
• Market makers step back to reduce exposure
• Creation/redemption is halted by the fund sponsor

Even then, ETF prices typically reflect the best available estimate of fair value — sometimes more accurately than the “official” NAV, which may be based on stale prices.

Practical implications for traders

Understanding creation/redemption changes how you think about ETF liquidity:

Liquidity is two-layered

A low-volume ETF tracking liquid securities (like S&P 500 stocks) can still handle large orders efficiently — APs can create/redeem shares using the liquid underlying securities.

Use limit orders

Since ETFs can trade at premiums or discounts to NAV, especially at market open or during volatility, limit orders protect you from executing at unfavorable prices.

Check iNAV for large trades

Most ETFs publish an intraday indicative NAV (iNAV) that updates every 15 seconds. For large trades, compare the quoted price to iNAV to ensure you’re not paying a significant premium (or selling at a discount).

Timing matters

Quick reference

The two markets

Key terms

The arbitrage loop

  flowchart LR
    subgraph Premium["**Premium Detected**"]
        A1[ETF price > NAV] --> A2[AP creates shares]
        A2 --> A3[Supply increases]
        A3 --> A4[Price falls]
        A4 --> A5[Premium shrinks]
    end
    
    subgraph Discount["**Discount Detected**"]
        B1[ETF price < NAV] --> B2[AP redeems shares]
        B2 --> B3[Supply decreases]
        B3 --> B4[Price rises]
        B4 --> B5[Discount shrinks]
    end

Sources

Learn more about the contents of this page by reviewing these sources: