How ETFs Are Constructed

An ETF manager or sponsor and an authorized sponsor or financial institution work with the U.S. Securities and Exchange Commission (SEC) to initiate a fund, acquire stock shares, and form ETF creation units. Stock shares are placed in trust to form ETF creation units.

Forming an ETF

ETFs are often compared to mutual funds but exchange-traded funds offer several benefits that mutual funds do not, including costs and taxes. The creation and redemption process for ETF shares is almost the opposite of that of mutual fund shares.

Investors send cash to the fund company when investing in mutual funds. The fund company then uses that cash to purchase securities and issue additional shares. Mutual fund shares are returned to the mutual fund company in exchange for cash when investors redeem them.

An ETF doesn’t involve cash transactions but securities are exchanged. An ETF is formed like this:

• A prospective ETF manager or sponsor files a plan with the U.S. Securities and Exchange Commission (SEC) to create an ETF. 
• Upon approval, the sponsor forms an agreement with an authorized participant, generally a market maker, specialist, or institutional investor, who will create and redeem ETF shares.
• The authorized participant acquires stock shares and places those shares in a trust and then uses them to form ETF creation units. The bundle quantities vary. They may be 25,000 or 50,000 shares designated as one creation unit.
• The trust provides shares of the ETF which are legal claims on the shares held in the trust to the authorized participant. Securities are traded for securities s =o there are no tax implications.
• The ETF shares are sold to the public on the open market like stock shares when the authorized participant receives them.
• The underlying securities borrowed to form the creation units remain in the trust account when ETF shares are bought and sold on the open market.

Redeeming an ETF

Investors have two options when they want to sell ETF holdings. They can:

• Sell the shares on the open market
• Gather enough shares of the ETF to form a creation unit then exchange the creation unit for the underlying securities.

The second option for redemption is generally only available to institutional investors due to the number of shares required to form a creation unit.

Tax Implications

All fund shareholders bear the tax burden when mutual fund investors redeem shares from a fund. The mutual fund may have to sell the securities, realizing the capital gain, which is subject to tax.

All mutual funds are required to pay out all dividends and capital gains. There’s still a tax liability on the capital gains realized even if the portfolio has lost unrealized value because of the requirement to pay out dividends and capital gains.

ETFs minimize this scenario by paying large redemptions with stock shares. The shares with the lowest cost basis in the trust are passed to the redeemer with these redemptions. This increases the cost basis of the ETF’s overall holdings, minimizing its capital gains.

The redeemer’s tax liability is based on the purchase price paid for the ETF shares, not the fund’s cost basis.

Trade Value and Arbitrage

Critics of ETFs often cite the potential for ETFs to trade at a share price not aligned with the underlying securities’ value. Assume an ETF is made up of only two underlying securities:

• Security X which is worth $1 per share
• Security Y which is also worth $1 per share

Most investors expect one share of the ETF to trade at $2 per share, the equivalent worth of Security X and Security Y, but this isn’t always the case. The ETF can trade at $2.02 per share or $1.98 per share or another value. 

Investors pay more for the shares than the underlying securities are worth if the ETF trades at $2.02. This would seem like a dangerous scenario for the average investor but the divergence is likely in fixed-income ETFs that are invested in bonds and papers with different maturities and characteristics, unlike equity funds.

This doesn’t usually pose a problem because of arbitrage trading. The arbitrageurs spring into action when the ETF’s price deviates from the underlying shares’ value. The arbitrageurs’ actions set the supply and demand of the ETFs back into equilibrium to match the value of the underlying shares. 

The Bottom Line

An ETF sponsor and an authorized sponsor or financial institution work with the SEC to initiate the fund, acquire stock shares, and form creation units. An ETF is priced at the close of each business day when trading. Tax liability is based on the purchase price paid for the ETF shares, not the cost basis when redeemed.

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