Creation and redemption

The wholesale mechanism by which large blocks of exchange-traded fund units are issued in exchange for a basket of the underlying securities, or cancelled in exchange for that basket.

Example

Buying a basket at 50.00 per unit and delivering it for 50,000 units worth 50.12 yields 6,000 gross, less the firm's own dealing costs of 4,500, leaving 1,500.

Important

It is why an exchange-traded fund's liquidity is largely the liquidity of its holdings rather than of its own volume - and why the market price converges to roughly the cost of the arbitrage rather than to zero difference.

Related terms

• Authorised participant — A firm permitted to create and redeem exchange-traded fund units in large blocks by delivering or receiving the underlying basket of securities.
• Premium or discount — The gap between an exchange-traded fund's market price and the net asset value of its holdings, expressed as a percentage of that value.
• Arbitrage — Buying and selling two forms of substantially the same thing at the same time to capture a price difference between them.
• Exchange-traded fund — A pooled fund whose units are listed and traded on an exchange throughout the session, at whatever price buyers and sellers agree rather than at the fund's own valuation.

Lessons that explain it

• A fund is a wrapper, not an asset class of its own — Buying a fund buys a proportional claim on whatever it holds. Until you have opened the holdings list, the name on the ticket tells you almost nothing about what you own. (9 min)
• Two prices: what the holdings are worth, and what somebody will pay — Net asset value is an accounting fact struck at a moment. An exchange-traded fund's market price is a live opinion. The gap between them is sometimes a mispricing and sometimes the more honest number. (12 min)

All 578 terms in the Investing glossary