How ETFs Are Constructed

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.

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.

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.

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.

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. 

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.