ETF Creation and Redemption Demystified

ETFs are desirable products. They’re low-cost, diversified, they trade all day on an exchange like a stock.

One thing that makes ETFs more desirable than their mutual fund counterparts is their inherent tax efficiency.  In general, ETFs are less likely to shoot off capital gains because they passively buy and hold baskets of stocks in an index, usually resulting in lower turnover and lower realization of capital gains.

In fact, Morningstar examined distributions by ETFs that track 27 indexes and found that ETFs in 25 of the categories had no capital gains distributions in the previous five years. The other two categories had very small distributions.

At the end of each year, fund providers list any expected distributions on their sites.

This is a function of the in-kind redemption process, which works like this:

• 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.

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. 

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.