How the ETF Creation/Redemption Process Works

One question we frequently receive has to do with the creation and redemption process of exchange traded funds (ETFs). This unique process is the reason ETFs are tax efficient.

But to understand how the process works, it helps to step back and look at how mutual funds operate. When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event.

ETFs can trigger taxable events, too - especially futures-based commodity funds and funds that have heavy turnover. But by and large, ETFs are tremendously tax-efficient because of the unique process by which new shares are created and redeemed:

• The creation process of an ETF begins with a prospective ETF manager, or sponsor, filing a plan with the Securities and Exchange Commission (SEC) to create an ETF.
• Once approved, the sponsor forms an agreement with an authorized participant (AP) – market maker, specialist or large institutional investor – who is able to create or redeem ETF shares.
• The authorized participant then borrows shares of stock and places them in a trust to form creation units of the ETF.
• The trust provides shares of the ETF that represent legal claims on the shares held in the ETF. The transaction is an in-kind trade where securities are traded for securities, which means no tax implications, since there was no cash changing hands.
• Finally, the AP receives the ETF shares, and the shares are then sold to the public as stocks in the open market. [ETFs and Taxes.]

The redemption process is as follows:

• First off, investors may sell shares on the open market – the more common option for investors.
• The second option is to hoard enough ETF shares to form a creation unit and then exchange the creation unit for an underlying security – the option more generally associated with institutional investors because of the large volume of shares required.
• When investors redeem, the creation unit is no more and the securities are handed over to the redeemer. [What are Capital Gains?]

 ETFs minimize tax liabilities by paying large redemptions with shares of stock and the shares with the lowest cost basis in the trust are given to the redeemer. The result is an increase in the cost basis of the ETFs overall holdings but a reduction in capital gains. The low turnover means that capital gains in ETFs are relatively rare as a result of the creation/redemption process.

You can never escape the tax man, so it’s best to be armed with all the information you need to deal with him when the time comes. Always know the tax implications of an ETF you’re holding and consult your tax professional for more information and guidance.

For more stories on taxes, visit our tax category.