An ETF manager or sponsor and an authorized sponsor or financial institution work with the U.S. Securities and Exchange Commission (SEC) to initiate a fund, acquire stock shares, and form ETF creation unit♛s. Stock shares are placed in trust to form ETF creation units.

Forming an ETF

ETFs are often compared to mutual funds but 澳洲幸运5官方开奖结果体彩网:exchange-traded funds offer several benefits that mutual funds do not, including costs and taxes. The creation and redemption process for ETF shares is almost the opposite of that of mutual fund shares.

Investors send cash to the 澳洲幸运5官方开奖结果体彩网:fund company when investing in mutual funds. The fund company then uses that cash to purchase securities and issue additional shares. Mutual fund shares are returned to the mutual fund company in🉐 exchange for cash when investors redeem them.

An ETF doesn't involve cash transactions but securities are exchanged. An ETF is formed like this:

• A prospective ETF manager or sponsor files a plan with the U.S. Securities and Exchange Commission (SEC) to create an ETF. 
• Upon approval, the sponsor forms an agreement with an 澳洲幸运5官方开奖结果体彩网:authorized participant, generally a market maker, specialist, or 澳洲幸运5官方开奖结果体彩网:institutional investor, who will create and redeem ETF shares.
• The authorized participant acquires stock shares and places those shares in a trust and then uses them to form ETF 澳洲幸运5官方开奖结果体彩网:creation units. The bundle quantities vary. They may be 25,000 or 50,000 shares designated as one creation unit.
• The trust provides shares of the ETF which are legal claims on the shares held in the trust to the authorized participant. Securities are traded for securities s =o there are no tax implications.
• The ETF shares are sold to the public on the 澳洲幸运5官方开奖结果体彩网:open market like stock shares when the authorized participant receives them.
• The 澳洲幸运5官方开奖结果体彩网:underlying securities borrowed to form the creation units remain in the trust account when ETF shares are bought and sold on the open market.

Redeeming an ETF

Investors have two options when they want to sell ETF holdings. T🉐hey can:

• Sell the shares on the open market
• Gather enough shares of the ETF to form a creation unit then exchange the creation unit for the underlying securities.

The second option for 澳洲幸运5官方开奖结果体彩网:redemption is generally only available to institutional investors due to the number of shares required to form a creation unit.

Tax Implications

All fund shareholders bear the tax burden when mutual fund investors redeem shares from a fund. The mutual fund may have to sell the securities, 澳洲幸运5官方开奖结果体彩网:realizing the 澳洲幸运5官方开奖结果体彩网:capital gain, which is subject to tax.

All mutual funds are required to pay out all dividends and capital gains. There's still a 澳洲幸运5官方开奖结果体彩网:tax liability on the capital gains realized even if the portfolio has lost unrealized value because of the requirement to pay out dividends and capital gains.

ETFs minimize this scenario by paying large redemptions with stock shares. The shares with the lowest 澳洲幸运5官方开奖结果体彩网:cost basis in the trust are passed to the redeemer with these redemptions. This increases the cost basis ꧙of the ETF’s overall holdings, minimizing its capital gains.

The redeeme🔥r’s tax liability is based on the purchase price paid for the ETF shares, not the fund’s cost basis.

Trade Value and Arbitrage

Critics of ETFs often cite the potential for ETFs to trade at a share price not aligned with the underlying securities’ value.ꦏ Assume an ETF is made up of only two underlying securities:

• Security X which is worth $1 per share
• Security Y which is also worth $1 per share

Most investors expect one share of the ETF to trade at $2 per share, the equivalent worth of Security X and Security Y, but this isn't always the case. The ETF can trade at $2.02 per share or $1.98 per share or another value. 

Investors pay more for the shares than the underlying securities are worth if the ETF trades at $2.02. This would seem like a dangerous scenario for the average investor but the divergence is likely in fixed-income ETFs that are invested in bonds and papers with differไent maturities and characteristics, unlike equity funds.

This doesn't usually pose a problem because of arbitrage trading. The arbitrageurs spring into action when the ETF’s price deviates from the underlying shares’ value. The arbitrageurs’ actions set the 澳洲幸运5官方开奖结果体彩网:supply and demand of the ETFs back into equilibrium&nb🐽sp;to match the value of the underlying shares. 

The Bottom Line

An ETF sponsor and an authorized sponsor or financial institution work with the SEC to🧸 initiate the fund, acquire stock shares, and form creation units. An ETF is priced at the close of each business day when trading. Tax liability is based on the purchase price paid for the ETF shares, not the cost basis when r♏edeemed.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our 澳洲幸运5官方开奖结果体彩网:warranty and liability disclaimer for more info.