Advisers interact with ETFs only in the secondary market but behind the scenes, in the ‘primary market’, different market participants work to ensure liquidity by creating or redeeming shares, as well as ensuring orderly and efficient trading. We have touched on market makers, so the other key players to consider are ‘authorised participants’, usually large financial institutions with direct access to the stock exchange. They have an agreement in place with the ETF issuer (the fund manager) that allows them to create and redeem ETF shares directly with the issuer of the fund.
An authorised participant applies to the issuer for whole creation units, typically 100,000 ETF shares or more. They can create ETF shares by delivering a physical collection of securities, referred to as a ‘basket’, or cash that equals the value of one unit (called an ‘in-specie’ or ‘in-kind’ transfer). In exchange, the authorised participant will receive a ‘creation unit’ of equal value; the ETF shares that made up the creation unit can then be sold to the market or held by the authorised participant. The ‘basket’ of securities is published each day and reflects the necessary value of cash or securities (with securities in weightings that closely replicate the value and profile of the index) that will need to be delivered by an authorised participant in exchange for ETF creation units. Units are redeemed by returning the ‘creation unit’ to the ETF issuer, in exchange for cash or securities. By creating and redeeming shares directly with the issuer in large blocks (in the primary market), authorised participants can provide liquidity to the market generally and also to large institutional investors who want to execute larger ETF trades. Some authorised participants are market makers, but not all.
Authorised participants calculate the value of the ETF securities continuously throughout the trading day. If the price of the ETF moves too far from the value of the underlying securities, they can use their creation/redemption facility to profit from it. When they do this they affect the price and it will tighten closer to NAV. This helps give investors confidence that the quoted market prices for an ETF closely match the value of the underlying portfolio and index that the ETF represents.
The primary market controls the number of ETF shares available to the market. This provides full liquidity in the secondary market because the issuer can create or redeem ETF securities to meet market demand. As demand for an ETF grows, more units can be created, thus increasing the fund’s assets under management like other open-ended investment funds.
