ETFs shares are regulated via a mechanism called ‘Creation and Redemption’. It involves large specialized investors, called authorized participants (APs).
If an ETF wants to distribute additional shares, the AP buys shares of the stocks from the index and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. When an AP sells stocks to an ETF sponsor for a share in the ETF it is called ‘Creation.’
Creation When Shares Trade at a Premium
Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per share basis, then the fund’s price of $101 is trading at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.
An authorized participant has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.
Redemption on the other hand proceeds if the number of ETF shares is reduced. This happens when an AP also buys shares of the ETF on the open market then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market.
The total of ‘redemption and creation’ activity is the capacity of demand in the market for whether the ETF is trading at a discount or premium to the value of the fund’s assets.
ETFs are just one of the investment specialties of Hanson Capital both locally and globally. We have a wide range of ideas we can propose to set for any investors. For more data and facts you may contact us.