The Hidden Mechanics of ETFs: APs, Creation Units, and Pricing (EP.246)

0:29We all need to make smart decisions with our money. we focused on how an ETF comes to market. This episode, though, is about what happens after that. Now, I think most people don't think about the underlying mechanics of ETFs until something feels off, but I think what you'll find is that understanding how ETFs work under the hood will make it a lot easier to identify good opportunities as well as situations you'd rather avoid. The three things that you'll understand at the end of this episode are who the authorized participants are, how ETF shares are created and redeemed, and why the trading price usually stays close to the value of what the fund owns.

1:08Once those pieces click, the benefits of the ETF structure and the caveats start to make a lot more sense. If you're enjoying these episodes, please do consider leaving a review on Apple Podcasts or Spotify or wherever you're listening to your podcasts. This is what helps other people like you find this information. Now, ETFs, they operate in two markets at the same time. The world you know is where ETF trades take place on an exchange. You can buy it at 10.07 a.m. and sell it at 1.12 p.m. and place a limit order if you want to control the price. That's known as the secondary market. Investors trading ETF shares with other investors.

1:49And if you only know that first world, ETFs can feel like mutual funds that trade like stocks. I hear that all the time. They're just mutual funds that trade like stocks. That's true on the surface, but it's not what makes them special. The other market is the one you don't see. It's called the primary market, and it's the direct channel between the ETF and a small group of large institutions known as the authorized participants or APs. The AP has a standing agreement with the ETF to create and redeem shares directly with the fund, or said differently, the AP can swap a basket of securities for a large block of ETF shares or swap ETF shares back for the underlying securities.

2:32And the AP will do this because they can profit when the ETF's trading price and the values of their underlying holdings drift apart. So that profit motive is usually a pretty good thing for retail investors because it's the reason ETF prices tend to stay close to the value of the underlying holdings. Now, let me explain that a little bit more. The NAV or the net asset value is the value of the ETF's underlying holdings divided by the number of shares outstanding. Mutual funds also calculate NAV, typically once at the end of the day, and that's the price everyone gets when they buy or sell. One price at the close.

3:08For ETFs, the market price is the live price of the ETF share on an exchange, and it moves throughout the day as buyers and sellers trade. And because of that, the market price and NAV won't perfectly match it every single moment. When the ETF trades above the value of its holdings, it's called a premium. When it trades below, it's called a discount. And this is where authorized participants come into play. When the premium or discount gets big enough to matter, APs have an incentive to step in and close the gap using creation and redemption. So here's what that looks like. Every day, ETFs publish a recipe, for lack of a better word, for what a creation unit looks like.

3:51In many ETFs, especially plain vanilla index ETFs, that recipe is a basket of securities that closely matches what the ETF holds. The basket might include hundreds of stocks in specific quantities, plus maybe a little bit of cash for rounding and expenses. And I can walk you through a simple example of both creation and redemption. So for creation, imagine that an ETF is getting a lot of buyer interest. Investors are hitting the buy button on their trading platform and the ETF's market price starts to creep a little bit higher than the value of its actual holdings. So in that environment, here's what can happen.

4:27The ETF is trading at a slight premium because demand is strong. An AP can buy the underlying baskets of securities in the market and then the AP can deliver that basket to the ETF. The ETF will issue the AP a creation unit of the new ETF shares, and then the AP can go sell those ETF shares into the market to meet investor demand, and that process increases the supply of the ETF shares available to investors. So instead of the price just rising because people want the ETF, new shares come into the system to meet demand and bring market price and NAV closer together. Now let's flip it for redemption.

5:05Imagine investors are selling the ETF heavily, and the trading price starts to drift a little below the value of its underlying holdings. In that case, the ETF is trading at a discount because its selling pressure is so strong, and the AP can buy ETF shares in the market at that discounted price. The AP then delivers a creation unit of the ETF shares back to the ETF, and then the ETF hands back the underlying basket of securities. And then the AP can sell those securities or use them to hedge. And that process reduces the number of ETF shares in circulation. So supply shrinks when demand shrinks.

5:41And this creation redemption process is one of the big reasons, it's really the big reason, that ETFs can handle big inflows and outflows without forcing the portfolio manager to constantly buy and sell just to accommodate investor activity. And that is where the tax story starts. So when people talk about ETFs being tax efficient, they're usually talking about in-kind creations and redemptions, meaning baskets of securities moving in and out of the fund, not cash. And here's why that matters. With a traditional mutual fund, if you and I are both in it together and I decide I'm going to liquidate my shares, the manager has to sell securities to raise cash and send me cash.

6:23But you're stuck with the tax bill. And so in the instance where sales result in gains, the fund may distribute those gains to the shareholders, even to the people who didn't sell. But with an ETF using in-kind redemptions, the fund can meet redemptions by handing securities out instead of selling them. And over time, what that does is it helps reduce the embedded gains inside the portfolio. And so for an ETF that you're holding in a taxable account, that often means fewer capital gains distributions. Now, a very common misconception is that all ETFs experience better tax efficiency than mutual funds.

6:58But this isn't always true, particularly for ETFs that rely more on cash creations and redemptions because building a clean basket is either harder or less efficient. So there are certain bond markets or some international exposures and definitely some active strategies where this applies. But as we talk about the creation redemption stuff, there's also these great innovations related to it, like the heartbeat trades or the ETF share classes of a mutual fund. But as I'm saying that and looking at the time, I do think that might be beyond the scope of this episode. I will find another time to talk about those, but I actually had an in-depth conversation with Marlena Lee on some of these things back in episode 232, which is titled The Latest Innovations in ETFs and Mutual Funds, if you want to go dig in on that right now.

7:44So what do these mechanics mean for you and what don't they mean? Well, first, there are fewer surprise capital gains distributions. In a taxable account, I think one of the most frustrating surprises is getting a capital gains distribution even when you didn't sell anything. And as we just covered, mutual funds may have to sell securities to meet redemptions, whereas ETFs can often deliver securities in kind. Now, over time, that also means that it can reduce the embedded gains inside the fund and further lower the odds of a capital gains distribution, especially for the broad liquid strategies.

8:18it's not a guarantee, but it is a real structural advantage. Another thing this means for you is that there's just more control over your trading price. The ETFs, they trade on exchange so you can buy and sell during the day, use limit orders to control your price. And it doesn't mean you should trade more, but it does mean that you have more control when you need to, whether that's through rebalancing or for raising cash or putting money to work. And the third thing, you know, and these are very big things, we can get into the nitty gritty in a future episode, but the third thing is that the transparency is really pretty unusual.

8:51I mean, most ETFs disclose their holdings regularly, whereas a mutual fund, it is not every day. ETFs, you're going to get it every day. And that's what makes it easier for the market makers and APs to manage the risk and tighter prices, which then further supports a smoothing trading experience for investors. The other thing that I think is a little less appreciated, especially among financial advisors, would be that transparency, I think, offers some pretty interesting lines of sight into the less liquid markets that happen to have ETFs on the secondary market. Now, in general, I hope I've made it clear, none of this means ETFs are automatically better.

9:27If an ETF relies heavily on cash creations and redemptions or holds harder to trade assets, it may not get the same tax or trading benefits. Some ETFs will still distribute capital gains in those instances, and some will trade with wider spreads. And because ETFs trade like stocks, I got to tell you, execution matters a lot. And so careless trading can turn a very good product into a frustrating experience. So the right takeaway of this episode isn't that ETFs are always better. I think it's just understanding that these mechanics can explain when ETFs tend to be more tax-friendly and cheaper to trade and when they won't be.

10:05And so I think now between this episode and last week's episode, I think we've successfully laid the groundwork for talking about 351 exchanges next week. So be sure to tune in for that one. And again, if you're enjoying these episodes, please take a moment to rate and review in Apple Podcasts or Spotify. That helps other people like you find the show. As always, thanks for listening. And until next time to Long-Term Investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com.

10:43Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.