Duration: 4:15
Level: Beginner

The Main Goals: Discover how assets move in and out of ETFs; Delve into how ETFs are created; and Learn how ETFs are redeemed.

Contributed By: WisdomTree U.S.

Study Notes:

This final lesson covers:

  • ETF creation and redemption
  • How assets move into and out of ETFs
  • Technology benefits of ETFs

For trading ETFs, there’s the secondary market and the primary market.

  • All investors transact in the secondary market.
  • Creations and redemptions take place in the primary market.

No investor can create / redeem on their own. You must be an authorized participant with the fund, which is a special agreement between the fund and the counterparty.

Secondary market trading

Investors trade ETFs on an exchange. They may be transacting with another investor who is selling their shares. At that point the transaction is done. A buyer and seller have been paired off.

However, it is more likely that an investor will be transacting with a “market maker” who is providing liquidity to buy or sell shares of the ETF to end investors.

The market maker will be pricing that ETF based on the fair value of the ETF, which is where they can sell the ETF and buy the underlying basket of securities. That is known as the “arbitrage mechanism”. Conversely, they will be buying ETFs where they can sell the underlying basket.

ETF creation

When market makers have sold more shares than they have, at the end of the day they need to come to the fund in the primary market and create new shares of the ETF. They will deliver that underlying basket that they were buying up all day long as they were selling the ETF, and they will deliver that basket to the fund.

The fund will take in those assets and they will create new ETF shares. They will deliver back those ETF shares to the authorized participant or the market maker to flatten out the short position they had at the end at the end of the day. The market maker has no position. They have delivered the basket and they have flattened out their short position. This is how assets move into the fund and how new shares are created. This is a back-office function that happens once a day at the net asset value of the fund.

ETF redemption

When investors want to sell shares of an ETF, they are generally selling those shares to the market maker. The market maker is buying those shares and they are selling the underlying basket to hedge themselves at the end of the day. When they own more shares of the ETF than they want, they will go to the fund as an “authorized participant” and say, “I would like to redeem these ETF shares.”

When they deliver back those ETF shares, the fund will retire those shares and they will take the pro rata basket of the assets in the fund and deliver that back to the market maker. Those are long basket shares collapsing that short position in the basket that they were hedging themselves with throughout the day. This also helps provide tax efficiency. The beauty of ETFs is they can often avoid capital gains distributions. Generally, that is because the fund can take low cost basis securities and push them out back to the market maker in an in-kind transaction where the fund is not needing to sell securities inside the fund and trigger capital gains events.

Insulation from transaction costs

With Exchange-Traded Funds, market makers are pricing the ETF at fair value and putting a spread around that, which is essentially the cost to transact in the underlying market. 3. With mutual funds, Portfolio Managers go outside the fund and transact in the underlying securities. Transacting in the underlying securities incurs commission costs and those commissions are shared by all investors and reduce the Net Asset Value.

Summary

In this course we covered:

  • What is an Exchange-Traded Fund?
  • How ETFs differ from mutual funds
  • Types of ETFs
  • Where you can buy and sell ETFs
  • How the basic structure of an ETF works
  • Secondary and Primary Market functions, including the creation and redemption of ETFs

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Disclosure: WisdomTree U.S.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. U.S. investors only: To obtain a prospectus containing this and other important information, please call 866.909.WISE (9473) or click here to view or download a prospectus online. Read the prospectus carefully before you invest. There are risks involved with investing, including the possible loss of principal. Past performance does not guarantee future results.

You cannot invest directly in an index.

Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, real estate, currency, fixed income and alternative investments include additional risks. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please see prospectus for discussion of risks.

WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S. only.

Interactive Advisors offers two portfolios powered by WisdomTree: the WisdomTree Aggressive and WisdomTree Moderately Aggressive with Alts portfolios.

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Information posted on IBKR Campus that is provided by third-parties does NOT constitute a recommendation that you should contract for the services of that third party. Third-party participants who contribute to IBKR Campus are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from WisdomTree U.S. and is being posted with its permission. The views expressed in this material are solely those of the author and/or WisdomTree U.S. and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

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The information in this material is provided for informational purposes only and does not constitute tax advice and cannot be used by the recipient or any other taxpayer to avoid penalties under any federal, state, local or other tax statutes or regulations, or to resolve any tax issue.