How an ETF really works

One fund, two markets

“I invested €1,000 in an ETF: that €1,000 went into the fund.” It is an intuitive explanation — but for most on-exchange purchases it is not what happens.

The retail investor operates on the secondary market. They buy a unit from whoever is selling it, through the exchange and the intermediaries that make the trade possible. Money passes from buyer to seller; ownership of the unit changes, while the total number of the fund’s units stays the same.

Alongside this market there is another, less visible one: the primary market. Here the fund can issue new units or cancel existing ones through the creation and redemption process. Direct access is normally reserved to professional parties admitted by the fund’s structure, often called authorized participants (APs) or, in European documentation, participating dealers.

The same unit therefore lives in two connected circuits:

This distinction clears up many misunderstandings, starting from the one in the previous chapter: knowing what you own is the first step; knowing how what you own is born is the second.

Who the authorized participant is

The authorized participant — or participating dealer, depending on the product’s terminology — is an intermediary with an agreement with the fund or its appointed agents to carry out creations and redemptions in the primary market. It can be a bank, a broker-dealer or another institution meeting the required operational standards.

The AP is not the small investor’s “representative” and does not manage the fund. It is the party that can deliver to the fund what the procedure requires and receive a block of units in exchange, or carry out the reverse operation.

Three roles are often confused:

• manager: decides or applies the investment policy and administers the portfolio;
• authorized participant: accesses the creation and redemption mechanism;
• market maker: quotes bids and offers on the secondary market, taking on and managing inventory risk.

The same institution can play more than one role, but it is not a necessary rule. A market maker can source or shed units through an AP; an AP is not obliged to quote continuous prices to the public. IOSCO’s 2023 Good Practices recommend that responsible entities assess and monitor any dependence on a limited number of APs and market makers: separating the roles also helps to see where activity might concentrate.

Creation: how a new unit is born

Units are not normally created one at a time to satisfy each retail order. The procedure works in blocks, often called creation units. The size of the block is set by the product’s documentation and operating rules: there is no universal number valid for every ETF and every market.

If 10 million units existed before the operation and 100,000 are created, after settlement there are 10.1 million. The fund’s assets have increased because it received new holdings; at the same time, the number of units sharing in those assets has increased.

A creation, taken in isolation, is not a gift to old or new investors. Assets delivered and units received must have consistent values under the fund’s rules, accounting for balancing amounts, fees and the costs of the operation.

Redemption: the reverse path

Redemption in the primary market follows the opposite route: the units gathered by the AP are cancelled and the fund returns assets or cash. If a fund goes from 10 million to 9.9 million units, its assets also fall by the value transferred to the AP. The remaining investors keep owning their fraction of the remaining assets: a properly settled redemption reduces numerator and denominator together.

Do not confuse it with a retail sale. When a saver sells ten units on exchange, those ten units are not necessarily redeemed and cancelled. They may simply end up in another investor’s portfolio or in an intermediary’s inventory. The primary market comes into play when an operator decides to aggregate units and use the redemption facility.

In kind, in cash, or hybrid

The most common picture shows the AP delivering all the index constituents and receiving ETF units. It is useful, but it does not describe every product.

In-kind creation and redemption. In the in-kind mode, the exchange happens mainly through securities or other assets. The fund receives or delivers a basket without having to buy or sell each position directly in the market for that specific operation. This can limit part of the trading costs borne inside the portfolio and attribute them more directly to whoever initiates the creation or redemption. It does not mean a “free operation”: the AP faces spreads, hedging, funding, settlement, taxes and fees, which shape the economic terms at which it is willing to operate.

Cash creation and redemption. In the cash mode, the AP transfers money and the fund or its agent buys the assets; on redemption the fund sells assets or uses cash to pay for the operation. This can be necessary or preferable when some securities are hard to transfer, local markets have operational constraints, or the strategy makes publishing or delivering the portfolio inappropriate. The costs generated must be handled according to the fund’s documents and the mechanisms designed to protect the other participants. “Cash creation” does not automatically mean the product is inefficient, but it changes who executes the trades on the underlying and where costs can emerge.

The hybrid model. Many processes combine securities with a cash component. Cash can serve for balancing amounts, accrued dividends, non-transferable positions or differences between the operational basket and the portfolio. The classification should not be reduced to an always-binary choice.

The creation basket is not necessarily the whole portfolio

Another misunderstanding comes from the word “basket”. The basket used on a given day for creation and redemption does not have to be a perfect copy of every position the fund holds.

A full-replication ETF may use a basket very close to the portfolio; a sampling fund may require only a representative set. There can also be cash components, operational exclusions and custom baskets allowed by the applicable rules. In active ETFs, managing portfolio information may require different solutions from a fully transparent index.

At least three objects must therefore be kept apart:

• index: the theoretical rule defining the exposure, where a replicated benchmark exists;
• fund portfolio: the assets actually held at a precise moment;
• creation/redemption basket: what is accepted or delivered in a specific primary operation.

They can be very similar without being identical. Rebalix shows the portfolio declared by the issuer — compositions photographed periodically, as you can see in the composition section of each fund page — and does not present it as automatic proof of the operational basket exchanged with APs.

Why the primary market exists

A traditional open-ended fund normally receives subscriptions and redemptions from investors at the value determined under its rules. An ETF adds intraday trading on the secondary market. Without a link to the portfolio, the units could become an object with rigid supply, whose price depends only on buyers and sellers.

Creation and redemption make the supply of units elastic instead. When there is an economic incentive, professional operators can create new units or withdraw them from the market. This links the market for the units to the market for the underlying assets.

The link is not a mathematical guarantee of perfect equality between price and portfolio value. It requires the operation to be possible, fundable and worthwhile. If the underlying markets are closed, illiquid or very volatile, if hedging costs rise, or if an operator hits its risk limits, the distance can widen.

The ECB has described ETF liquidity as the result of the interaction between creations and redemptions, market making, secondary trading and hedging activity in related markets. The mechanism should be thought of as an economic system, not an automatic button.

Price, NAV, premiums and discounts will be the focus of the next chapter. Here it is enough to fix the relationship: the primary market makes arbitrage possible, but does not promise it will always be immediate or free.

Where an ETF’s liquidity comes from

Looking only at how many units traded today can be misleading. Liquidity has several layers:

• units already available and traded on the secondary market;
• market makers’ inventory and risk capacity;
• the ability to create or redeem units;
• liquidity, hours and costs of the underlying assets;
• instruments usable for hedging, such as futures or other related markets.

An ETF with low visible volumes can have a very liquid underlying and allow large trades at reasonable terms. Conversely, an ETF with high historical volumes can become expensive to trade if the underlying is under stress.

This does not license ignoring volume and spread. It only means they are partial snapshots. Spread, book depth, trading hours and order types will be covered in the chapter on tradability.

What happens when “money flows into” an ETF

The expression “inflows into the ETF” can refer to different phenomena.

If an investor buys units from another investor, there is a secondary-market trade but no automatic net subscription into the fund. If demand leads to net creations, units and assets both rise. If redemptions prevail, both fall.

Nor does a rise in AUM necessarily coincide with new subscriptions. Assets can grow because:

• prices of the assets already held go up;
• new assets come in through net creations;
• income is reinvested;
• the exchange rates used to express the assets change;
• several factors combine.

Separating performance from flows requires consistent data on units outstanding, NAV and currency — not just two successive AUM values. That is why Rebalix presents the assets history as a documentary snapshot and does not automatically turn every increase into “inflows”. The criterion is described in the methodology.

The mechanism also applies to active and synthetic ETFs

ETF does not necessarily mean passive management. An active ETF can issue and redeem units through the same general principle, even if the composition and publication of the operational basket may be adapted to the strategy and the regulatory framework.

Nor does synthetic replication mean the primary mechanism is absent. A synthetic ETF is still a fund: creation and redemption concern its units, while the economic exposure to the index comes wholly or partly from a swap. The substitute portfolio is the set of securities the fund actually holds while the index return comes from the swap; substitute portfolio, derivative contract and operational basket are therefore distinct elements.

This is the connection with the Rebalix guide on physical and synthetic replication: understanding how units are created is not enough to establish how the fund obtains the index return.

Five mistakes to avoid

• “Every retail purchase makes the fund buy securities.” Normally the order meets an existing unit on the secondary market.
• “Authorized participant and market maker are synonyms.” The roles can overlap, but they have different functions.
• “The creation basket always coincides with the index.” Index, portfolio and operational basket are three distinct objects.
• “In-kind means cost-free.” Trading, hedging, funding and settlement costs continue to exist.
• “Arbitrage always keeps price and NAV identical.” It is an economic incentive conditioned by costs, risk and operations — not a guarantee.

Chapters 3 and 4 — price, NAV and arbitrage; liquidity, spreads and orders — are next in the series, coming soon.