Exchange-traded funds (ETFs) can provide investors with superior liquidity, lower costs, and greater tax efficiency relative to other investment vehicles. A look “behind the curtain” at the workings of the primary markets helps to explain what enables ETFs to offer such distinctive characteristics for investors. Our primer below breaks it down.
The workings of the ETF primary market
ETF shares are created and redeemed in the primary market between the ETF and an Authorized Participant (AP). APs, large financial institutions with the contractual ability to transact directly with an ETF, provide considerable underlying liquidity in the ETF market and increase market transparency by keeping ETF prices close to their net asset values.
Share creation transactions are conducted in-kind1 by exchanging ETF portfolio securities for ETF shares. As such, the AP bears trading costs for purchasing portfolio securities (in a share creation transaction) or selling securities received (in a share redemption transaction) in the open market. Since redemption trades are executed in-kind, and the Internal Revenue Code enables the ETF to forgo realization of a related taxable gain/loss, by extension, ETFs can operate with lower costs and greater tax efficiency.
As illustrated below, trading in the primary market exists on an over-the-counter basis between the AP and ETF issuer, and is facilitated through the ETF’s distributor, custodian, and transfer agent. Our primary market creation graphic (Figure 1) shows how the AP works with an ETF issuer, with the underlying securities delivered from the AP to the ETF, and the AP receiving newly created ETF shares in exchange. Conversely, for a primary market redemption order, the AP delivers existing ETF shares in exchange for the underlying ETF portfolio securities.