Creation and redemption is how ETFs are made and destroyed. Understanding creation and redemption is crucial to understanding ETFs and crucial to understanding why ETFs are a superior financial technology in many respects to close-ended funds.
An important difference between ETFs and closed-ended funds is how they react to supply and demand. The supply of closed-ended funds cannot be increased when demand shoots up: there are a fixed number of the fund’s units that trade on any exchange.
This means that if a closed-ended fund gets really hot and popular with investors, they trade at premiums – where the fund costs more to buy than the value of its holdings. Conversely, the supply of a close ended fund cannot be decreased when demand falls, meaning that the fund can trade at a discount when no-one wants it.
But ETFs have a magical power to change their supply as demand rises and falls. This magical power is called “creation and redemption”. It also allows ETFs to ensure they are priced fairly even as investor demand swings wildly. So how does it work?
Each ETF is stalked by several strange creatures that are called “authorised participants,” (APs) which are usually investment banks. The APs are the gatekeepers determining how many ETFs get made and destroyed and they work closely with ETF providers to “make a market” for any ETF.
When APs want to create more ETFs – usually owing to investor’s demand – they do the following.
Firstly, they go buy all the shares that are in the index an ETF tracks. So, say, for any FTSE 100 ETF, an AP would go and buy all the shares in the FTSE 100 – your HSBC, Shell, BP, etc.
Second, they bring the basket of FTSE 100 shares to the ETF provider and typically pay a small ‘creation fee’. The ETF provider then gives them FTSE 100 ETFs in exchange for the basket. This ‘creation’ mechanism ensures that there are always enough ETFs to go around, and that they never really have to trade at premiums owing to too much demand.
Redemption just works the other way. It is when APs want to destroy ETFs thinking there are too many of them in the market.
Let’s say for example, that everyone is getting a bit fed up with British ETFs (due to Brexit, Corbyn, or whatever else) and a lot of investors choose to dump FTSE 100 ETFs en masse. For any close ended funds tracking the FTSE 100, this type of quick-fire dumping could well cause them to trade at discounts due to a lack of demand and no way to constrict supply.
But for ETFs this is no problem as they can be redeemed and destroyed. The way this works is that our APs bring the ETFs to the ETF provider and ‘redeem’ them for shares in FTSE 100 companies. And voila, the supply of FTSE 100 ETFs constricts.