ETF creation and redemption is the process an exchange-traded fund uses to issue new shares and cancel existing ones. Only an authorized participant (AP), a clearing firm with a written agreement with the fund, can take part: it delivers a basket of securities or cash and receives a block of new shares called a creation unit, or hands a block back and receives the basket. Everyone else buys and sells existing shares on an exchange. What is an ETF covers the fund itself, and the stocks hub links the related guides.
How does ETF creation and redemption work, step by step?
An AP swaps a basket of assets for a block of new ETF shares at that day's NAV, and the fund reverses the swap when the AP hands shares back.
- The fund sets the basket. Each business day an ETF publishes its creation and redemption baskets for the next trading day, ICI says, and under Rule 6c-11 it must also post every portfolio holding behind its next NAV before the market opens.
- The AP places an order for one or more creation units, typically 50,000 shares each. The price is the NAV at the end of the day the order is placed.
- The AP delivers the basket, plus a cash balancing amount covering any difference between the basket's value and the unit's NAV, and may pay a transaction fee to offset the fund's costs.
- The fund issues the shares. The AP can keep them, pass them to clients or sell them on an exchange or another trading venue.
- Redemption runs backward. The AP gathers a creation unit's worth of shares, returns it and receives the redemption basket, which typically mirrors the creation basket.
APs are typically large, self-clearing broker-dealers, and ICI notes that the fund does not pay them and they have no legal obligation to create or redeem. They act when it suits their own trading books or their clients, such as market makers and hedge funds. In 2024 the average ETF had 18 registered APs, of which four were active.
What is the difference between in-kind and cash creation?
In kind, the AP and the fund swap securities for shares; in cash, the AP pays or receives money and the fund trades the holdings itself.
| In kind | In cash | |
|---|---|---|
| AP delivers on creation | The basket of securities and any cash balancing amount | Cash equal to the creation unit's NAV |
| AP receives on redemption | Securities from the portfolio | Cash |
| Who trades the underlying holdings | The AP | The fund, which may charge the AP a fee to cover the cost |
| Tax effect for a US fund on redemption | No gain recognized on securities handed over | Selling holdings for cash can realize gains |
| Where it is used | The usual method, according to the SEC's investor bulletin | Holdings that are hard to obtain, barred to some investors or thinly traded |
Many funds mix the two. ICI says an ETF may let or require an AP to substitute cash for securities that are hard to get or that certain investors may not hold, such as some foreign shares, and a bond ETF's mix of cash and bonds in its baskets can change daily with liquidity in the bond market. The SEC's 2019 rule release noted that fixed-income ETFs may meet redemptions entirely in cash to avoid giving away hard-to-find bonds, and that funds doing so may hold more cash, a drag on returns.
Spot bitcoin and ether exchange-traded products, which are trusts rather than registered funds, could create and redeem only in cash until July 29, 2025, when the SEC approved orders letting them transact in kind; bitcoin ETFs vs owning bitcoin compares them with holding coins directly.
How does arbitrage keep an ETF's price near its NAV?
Whenever shares trade far enough above or below the basket's value to cover costs, APs create or redeem, and their trades push the price back toward NAV.
Worked example: What a premium or discount is worth to an AP
Assume an ETF with a NAV of $40.00, creation units of 50,000 shares worth $2,000,000, a $250 transaction fee per order and trading costs of 0.05% on the basket. The figures are illustrative.
Shares trade at $40.10, a 0.25% premium:
- Buy the basket for $2,000,000 plus $1,000 of trading costs, and pay the $250 fee
- Receive 50,000 new shares and sell them for $2,005,000
- Profit: $2,005,000 − $2,001,000 − $250 = $3,750
Shares trade at $39.92, a 0.20% discount:
- Buy 50,000 shares for $1,996,000 and redeem them, paying the $250 fee
- Sell the basket for $2,000,000 less $1,000 of trading costs
- Profit: $1,999,000 − $1,996,000 − $250 = $2,750
Costs total $1,250, about 0.06% of the unit, so in this setup a smaller gap is not worth closing.
ICI describes how traders lock in a gap during the day: at a discount, a trader buys the ETF's shares and shorts the underlying securities, then has an AP redeem the shares at the close and covers the short with the basket. The SEC's 2019 release called this arbitrage the foundation for why ordinary investors can generally trade ETF shares at or near the prices APs get from the fund, and its staff found closing-price deviations from NAV in 2017 and 2018 rare and generally not persistent.
The band widens when costs or uncertainty rise. Thinly traded bonds carry wider bid-ask spreads, and in stressed markets the SEC has seen gaps widen for short periods, when APs and market makers can find it hard to value the holdings precisely enough to hedge. The net asset value entry shows how large those gaps have been, and SPY's price page tracks one fund whose share price this arbitrage keeps tied to its holdings.
Why does in-kind redemption make ETFs tax-efficient?
A US fund that hands appreciated securities to a redeeming shareholder recognizes no gain, and it can choose which tax lots to hand over.
A corporation that distributes appreciated property is normally taxed as though it had sold it, under section 311(b) of the Internal Revenue Code. Section 852(b)(6) turns that rule off when a regulated investment company distributes property to redeem shares at a shareholder's demand, which describes an in-kind ETF redemption. Because the fund also decides which lots of each holding go out, it can send out the shares with the lowest cost basis and keep the dearer ones.
Worked example: Which tax lots leave the fund
An ETF owns 30,000 shares of one stock, now priced at $100, bought in three lots of 10,000 at $40, $70 and $95. An AP redeems, and the basket calls for 10,000 shares.
- Delivered in kind from the $40 lot: $1,000,000 of stock leaves carrying $600,000 of unrealized gain, and the fund recognizes none of it
- Built-in gain left in the fund: $300,000 on the $70 lot and $50,000 on the $95 lot, $350,000 in all, down from $950,000
- A mutual fund paying the same $1,000,000 redemption in cash must sell; even selling the $95 lot realizes $50,000 of gain, and the $40 lot's $600,000 stays behind for later
The SEC's investor bulletin draws the conclusion: because many ETFs trade portfolio securities in kind, they typically have fewer capital gain distributions than mutual funds. Rule 6c-11 also permits custom baskets, which need not be a pro rata slice of the portfolio, giving a manager more say over what leaves, provided the fund has written policies governing their use. How often each fund type has paid out gains is covered in ETFs vs mutual funds vs index funds and the capital gains distribution entry.
How does the primary market differ from trading ETF shares on an exchange?
Creations and redemptions happen in the primary market between APs and the fund, while everyday trading happens in the secondary market between investors.
| Term | What it is | How it differs |
|---|---|---|
| Primary market | Creations and redemptions between APs and the fund at NAV | Changes the number of shares outstanding |
| Secondary market | Investors trading existing shares on an exchange at market prices | The fund is not involved, and no shares are created |
| Authorized participant | A clearing firm with a written agreement to place creation and redemption orders | Can deal with the fund directly but is not obliged to |
| Market maker | A firm that quotes bids and offers in the ETF's shares | Supplies trading liquidity and reaches the fund through an AP |
| Mutual fund purchase or redemption | Any investor buying or selling shares directly with the fund at the next NAV | Usually settled in cash, with no AP or minimum block |
What mistakes do people make about ETF creation and redemption?
The most common is assuming money invested in an ETF flows into the fund, when a purchase on the exchange normally just moves existing shares from a seller to you.
- Reading trading volume as fund flows. A day of heavy trading may involve no creations or redemptions at all, since the fund only sees AP orders.
- Treating NAV as a guaranteed exit price. APs act only when it pays, so in a disorderly market the share price can stay well away from NAV for a while. A limit order caps what you pay or receive.
- Assuming in-kind means tax-free. The benefit belongs to the fund: you still owe tax on dividends and on your own gain when you sell. ETFs that redeem in cash get less of it, and funds domiciled outside the US, such as UCITS ETFs in Ireland or Luxembourg, are taxed under their own countries' rules, not section 852.
- Counting the transaction fee as your cost. APs pay it, and Form N-1A lets funds with creation units of at least 25,000 shares leave it out of the fee table. Your own costs are the expense ratio, the bid-ask spread and any premium you pay.