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ETF Creation and Redemption Mechanism

This is the mechanism that makes ETFs work, and it is the most commonly asked ETF interview topic.

The elastic share count

Unlike a company, an ETF's share count is not fixed. Shares are created when demand rises and redeemed when it falls, by a small group of large firms called authorised participants.

Creation: the AP delivers the underlying basket to the issuer and receives new ETF shares.

Redemption: the AP delivers ETF shares and receives the basket back.

Both are usually in kind: securities exchanged for shares, no cash involved.

One unit is a scaled copy of the entire basket, which is what makes the exchange work in either direction: the AP is handing over exactly what the fund holds, in proportion.

The arbitrage loop

Suppose an ETF trades at 100.50 while its basket is worth 100.00. The ETF is expensive relative to what it holds, so the AP:

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