How an ETF is Created

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An ETF has many advantages over a mutual fund including costs and taxes. The creation and redemption process for ETF shares is almost the exact opposite of that for mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which then uses that cash to purchase securities and in turn issues additional shares of the fund. When investors wish to redeem their mutual fund shares, they are returned to the mutual fund company in exchange for cash. Creating an ETF, however, does not involve cash.

The process begins when a prospective ETF manager (known as a sponsor) files a plan with the U.S. Securities and Exchange Commission to create an ETF. Once the plan is approved, the sponsor forms an agreement with an authorized participant, generally a market maker, specialist or large institutional investor, who is empowered to create or redeem ETF shares. (In some cases, the authorized participant and the sponsor are the same.)

The authorized participant borrows stock shares, often from a pension fund, places those shares in a trust and uses them to form ETF creation units. These are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares is what's commonly designated as one creation unit of a given ETF. Then, the trust provides shares of the ETF, which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units), to the authorized participant. Because this transaction is an in-kind trade — that is, 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 just like stock shares.

When ETF shares are bought and sold on the open market, the underlying securities that were borrowed to form the creation units remain in the trust account. The trust generally has little activity beyond paying dividends from the stock, held in the trust, to the ETF owners, and providing administrative oversight. This is because the creation units are not impacted by the transactions that take place on the market when ETF shares are bought and sold.

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