An ETF sponsor collaborates with an authorized sponsor or financial institution and the SEC to launch a fund, acquire stock shares, and establish creation units. Every trading day concludes with the pricing of an ETF. When redeemed, the tax obligation is determined by the purchase price of the ETF shares, not the fund’s cost basis.

Key Considerations

Two routes exist for investors aiming to offload ETF holdings. They may choose to:

• Dispose of shares on the open market.
• Accumulate enough ETF shares to assemble a creation unit, then swap the creation unit for the underlying securities.

This second approach is predominantly accessible to institutional investors due to the substantial share volume needed to form a creation unit.

ETF formation is a cooperative effort between an ETF manager or sponsor and an authorized participant or financial institution. They launch a fund, acquire stock shares, and create ETF creation units by placing the stock shares in trust.

While exchange-traded funds (ETFs) are typically juxtaposed with mutual funds, their benefits are distinct. An ETF manager or sponsor submits a plan to the SEC to craft an ETF. An agreement is forged between the sponsor and an authorized participant—often a market maker or institutional investor. Trust holds the stock shares, forming ETF creation units.

ETFs are frequently likened to mutual funds, though investing in mutual funds differs. The fund company utilizes cash to buy securities and distribute additional shares. When investors redeem mutual fund shares, they receive cash in return from the mutual fund company.

Unlike cash transactions, ETFs use securities in exchanges. An ETF’s creation unfolds as follows:

Potential ETF managers or sponsors collaborate to initiate the fund, securing bundles of shares. These bundles, labeled as creation units, may comprise 25,000 or 50,000 shares each. Authorized participants receive ETF shares from the trust, representing legal claims on the shares held in trust. Securities are swapped for securities, negating tax consequences. These ETF shares are offered to the public via the NYSE Arca, Cboe BZX, and Nasdaq exchanges starting January 2024. Spot bitcoin ETFs offer investors the chance to gain bitcoin exposure within their brokerage accounts.

ETFs operate as open-ended funds, allowing the market price to deviate from the NAV of the fund’s portfolio. In cases of divergence, traders might redeem shares to acquire undervalued ones or sell baskets to form new ETFs. Such arbitrage activities generally align the NAV with the market price, enhancing ETF liquidity.

All fund holders bear responsibility for capital gains taxes, even if the portfolio’s unrealized value has diminished, due to dividend and capital gains distributions.

To mitigate this, ETFs satisfy substantial redemptions via stock shares. Shares with the lowest cost basis are transferred to the redeemer during these redemptions. This strategy elevates the ETF’s overall holdings’ cost basis, reducing capital gains.

The redeemer’s tax responsibility hinges on the ETF shares’ purchase price, not the fund’s cost basis.

Fast Fact

ETFs remain unaffected by gains or losses when redeemers sell stock shares on the open market. Investors with modest portfolios are safeguarded from decisions made by those with extensive portfolios.

Detractors of ETFs often underscore the risk of ETFs trading at prices that diverge from the intrinsic value of the underlying securities. Consider an ETF comprising two underlying securities:

• Security X, valued at $1 per share.
• Security Y, likewise worth $1 per share.

A common expectation among investors is for one ETF share to trade at $2, reflecting the combined value of Security X and Security Y. However, this isn’t consistently accurate. The ETF might trade at $2.02, $1.98, or another valuation.

When ETFs trade at $2.02, investors pay a premium compared to the intrinsic value of the underlying securities. While potentially perilous for average investors, this discrepancy is more likely in fixed-income ETFs. These invest in bonds and papers with varying maturities and attributes, unlike equity funds.

Typically, this isn’t disruptive due to processes that restore ETFs to equilibrium, aligning with the underlying shares’ value.

How Is an ETF’s Trading Price Established?

The ETF’s trading price is determined at the business day’s end. Each day, ETF sponsors disclose the underlying shares’ value. Subsequently, ETF shares trade on the open market, with their market price potentially diverging from the portfolio’s NAV (Net Asset Value).

Are Redeemed Shares of an ETF Traded on the Secondary Market?

ETF shares can be reverted to the sponsor in exchange for the stocks they represent. Upon being redeemed, these ETF shares cease trading on the secondary market.

Why Do ETFs Need a Creation and Redemption Mechanism?

ETFs, being open-ended funds, experience market prices that may deviate from the NAV of the fund’s portfolio. If the market price deviates upwards, traders might redeem their shares to secure undervalued shares. Conversely, if the price falls below the NAV, they might sell the basket to create new ETFs. This arbitrage typically harmonizes the NAV with the market price, bolstering ETF liquidity.

These online discussions, opinions, and analyses are meant purely for informational purposes. For further details, consult our resources.