How ETFs Work

Unlike mutual fund shares, ETF shares are traded on an exchange, so investors purchase and sell ETF shares in market transactions. ETF shares are purchased from, and sold to, other investors. This contrasts with a mutual fund, where an investor buys a share directly from the mutual fund, and then "sells" or "redeems" those shares from the mutual fund itself.

When an ETF initially goes public, or when an ETF wants to issue additional shares, it does so by selling shares to one or more financial institutions known as “Authorized Participants.” Authorized participants typically are large broker-dealers. Only authorized participants are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks commonly called “creation units” or a "creation basket". Each ETF can specify how big the creation basket is.

To purchase shares from an ETF, an authorized participant assembles and deposits a designated basket of securities and cash with the fund in exchange for which it receives shares in the ETF. Once the authorized participant receives the ETF shares, the authorized participant is free to sell the ETF shares in the secondary market to individual investors, institutions, or market makers in the ETF.

The redemption process is the reverse of the creation process. An authorized participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the authorized participant receives a pre-defined basket of individual securities, or the cash equivalent. Most ETFs charge the authorized participants a fee for each of these "creation basket" transactions, but it is usually not very large.

Benefits

  • Lower costs of fees charged

  • Instant diversification

  • Liquidity

  • Tax Efficiency

  • Sector investing

  • The ability to purchase in small amounts

  • The availability of a wide variety of alternative investments