How ETFs Are Constructed

Reviewed by Julius MansaFact checked by Michael RosenstonReviewed by Julius MansaFact checked by Michael Rosenston

ETFs are often compared to mutual funds, but exchange-traded funds offer several benefits that mutual funds do not. An ETF manager or sponsor and an authorized sponsor or financial institution work with the U.S. Securities and Exchange Commission (SEC) to initiate the fund, acquire stock shares, and form ETF creation units.

Key Takeaways

• Exchange-traded funds (ETFs) are commonly compared to mutual funds but offer different benefits.
• An ETF manager or sponsor files a plan with the SEC to create an ETF. 
• The sponsor forms an agreement with an authorized participant, generally a market maker or institutional investor.
• Stock shares are placed in trust to form ETF creation units.

Forming an ETF

An ETF has many advantages over a mutual fund, including costs and taxes. The creation and redemption process for ETF shares is almost the opposite of mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which uses that cash to purchase securities and issue additional shares.

When investors redeem their mutual fund shares, they are returned to the mutual fund company in exchange for cash. An ETF does not involve cash transactions, but securities are exchanged. An ETF is formed in the following way:

• 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, then uses them to form ETF creation units. The bundle quantities vary, such as 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. Because securities are traded for securities, there are no tax implications.
• Once the authorized participant receives the ETF shares, they are sold to the public on the open market like stock shares.
• When ETF shares are bought and sold on the open market, the underlying securities borrowed to form the creation units remain in the trust account.

Spot Bitcoin ETFs

In Jan. 2024, the SEC approved eleven spot bitcoin ETFs listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. Spot bitcoin ETFs allow investors to gain exposure to bitcoin within their brokerage account.

Redeeming an ETF

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

Spot Ether ETFs

On May 23, 2024, the SEC signaled its increased likelihood of allowing spot ether ETFs to eventually be listed on US exchanges when it approved the applications of NYSE, CBOE, and Nasdaq to list those products. The spot ether ETF issuers will still need to get approval for their products.

Tax Implications

When mutual fund investors redeem shares from a fund, all fund shareholders bear the tax burden.This is because 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.Even if the portfolio has lost unrealized value, there is still a tax liability on the capital gains realized because of the requirement to pay out dividends and capital gains.

ETFs minimize this scenario by paying large redemptions with stock shares. With these redemptions, the shares with the lowest cost basis in the trust are passed to the redeemer. 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.

Important

When the redeemer sells the stock shares on the open market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios.

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 is not always the case. The ETF can trade at $2.02 per share or $1.98 per share or other value. 

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

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

How Is an ETF’s Trading Price Established?

The ETF’s trading price is established at the close of the business day. ETF sponsors also announce the value of the underlying shares daily. The ETF shares then trade on the open market, where their market price may diverge from the net asset value (NAV) of the portfolio.

Are Redeemed Shares of an ETF Traded on the Secondary Market?

ETF shares can be passed back to the sponsor in return for the basket of stocks that these shares represent. In doing so, the ETF shares redeemed no longer trade on the secondary market.

Why Do ETFs Need a Creation and Redemption Mechanism?

ETFs are structured as open-ended funds, so the market price of the ETF shares may diverge from the NAV of the fund’s portfolio. If the market price diverges to the upside, traders may seek to redeem their shares and obtain the underpriced shares. If the price drops below the NAV, traders may sell that basket to create new ETFs. This type of arbitrage activity keeps the NAV and market price in line most of the time and increases ETF liquidity.

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. When trading, an ETF is priced at the close of each business day. When redeemed, tax liability is based on the purchase price paid for the ETF shares, not the cost basis.

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