How ETFs work: creation, redemption, NAV and the arbitrage band

Most explanations of exchange-traded funds stop at "authorized participants create and redeem shares, and arbitrage keeps the price near NAV." That sentence is true, but it hides the parts that decide whether a particular ETF trades well: who is allowed to create shares, what they deliver, what it costs them, how far the price has to stray before the trade pays, and what happens when the underlying market is closed or frozen.

This guide opens the machine. It assumes you know what an ETF is (if not, start with What is an ETF? How exchange-traded funds work) and that ETFs are usually more tax-efficient than mutual funds (covered in ETFs vs. mutual funds: costs, taxes, trading and which fits). Here we go one level down: the participants and documents involved in a creation, a worked arbitrage trade with costs that shows why premiums and discounts sit inside a band, the intraday value estimate and why the SEC stopped requiring it, the precise tax rule behind in-kind redemptions, and what US Rule 6c-11 makes every standard ETF disclose.

The cast: who does what

A US ETF is an investment company with several distinct roles around it.

• The sponsor and adviser design the fund, choose or build the index, and manage the portfolio.
• The custodian, usually a large bank, holds the fund's securities and processes the deliveries when shares are created or redeemed.
• Authorized participants are broker-dealers that have signed an agreement with the fund allowing them to create and redeem shares. The SEC's investor bulletin describes them as typically large broker-dealers and says they are typically the only parties that buy and redeem shares directly from the ETF.
• Market makers, including a lead market maker assigned by the listing exchange, post bids and offers for the ETF all day. Many market makers are also APs or trade through one.
• Investors buy and sell existing shares on the exchange and never deal with the fund.

The key point is that the fund does not care how much ETF trading happens on the exchange. A share that changes hands between two investors leaves the fund untouched. The fund's size changes only when an AP creates or redeems.

Anatomy of a creation

Each business day before the market opens, the fund publishes what an AP must deliver to create one creation unit. The document is usually called the portfolio composition file, and it has two parts:

1. The basket: a list of securities and share quantities, usually a pro-rata slice of the portfolio.
2. The cash component: a balancing amount that makes the basket's value equal the NAV of one creation unit. It covers accrued dividends, cash the fund holds, and any securities left out of the basket.

The AP delivers the basket and the cash to the custodian and receives a creation unit of new ETF shares. Funds set their own unit sizes; the SEC's bulletin uses 50,000 shares as an example. Most funds also charge a fixed transaction fee per creation or redemption order, disclosed in the prospectus, to cover the custodian's processing costs.

Some baskets are not a pro-rata slice. A bond fund may hold thousands of issues, many of which trade rarely, so it may accept a smaller representative set of bonds. Rule 6c-11 calls a basket that differs from the pro-rata portfolio, or that differs from other baskets on the same day, a custom basket, and allows it only if the fund has written policies setting its parameters and naming who reviews it.

Some creations are done partly or wholly in cash. That happens when a holding cannot easily be delivered, for example in markets with transfer restrictions, or when the fund prefers to buy the securities itself. Cash creations work the same way in principle, but the fund has to trade, and it usually charges a variable fee so that the cost lands on the AP rather than on existing shareholders.

The arbitrage band, worked through with costs

The arbitrage trade is profitable only after the AP pays to trade the basket. That cost is what sets how far an ETF's price can drift from its NAV.

The break-even point in that example is a discount of about 0.36%: the 0.35% trading cost plus the $500 fee, which is 0.01% of $5 million. Inside that band, the price can wander without anyone having a profitable trade to push it back. Outside it, redemptions (or, for a premium, creations) pull the price back toward the edge of the band.

This explains the pattern you see across funds. A large S&P 500 ETF holds stocks with spreads of a cent or two, so its band is tiny and its price rarely strays more than a few hundredths of a percent. A high-yield bond ETF holds bonds that may cost much more to trade, so its band is wider, and in a stressed market, when bond spreads blow out, the band widens with them.

Why the discount in a crisis is not necessarily a fault

When bond markets seize up, the bonds in a fund may not have traded for days, and NAV is calculated from evaluated prices, which are estimates. The ETF, meanwhile, keeps trading on the exchange. Its price can then fall below NAV. Part of that gap is the wider band. Part of it may be that the ETF price is the more current estimate of what the bonds would fetch if sold today. A discount in a stressed market can mean the NAV is stale, not that the ETF is broken.

NAV, iNAV and fair value

NAV is computed once a day, usually as of the 4:00 p.m. ET close. Under the Investment Company Act, holdings with readily available market quotations are valued at market. Everything else is valued at fair value, a good-faith estimate under procedures the fund's board oversees. That is why a fund of Japanese stocks, whose home market closed hours before New York, may adjust its NAV for news that arrived after Tokyo shut.

The intraday indicative value (IIV, also called iNAV) is an estimate of NAV per share during the trading day, calculated from the latest prices of the basket. Exchange listing standards required it to be disseminated at least every 15 seconds when the SEC adopted Rule 6c-11 in 2019. The SEC chose not to require it as a condition of the rule. In the adopting release, the Commission said the IIV can be stale or inaccurate for ETFs holding foreign securities or less liquid debt, that dissemination lags can make it inaccurate even for funds of heavily traded stocks, and that there is no uniform method for calculating it. It also said it understood market makers and APs no longer relied on it, since they price the published basket themselves.

For an investor, the practical lessons are:

• For a fund of US large-cap stocks during regular hours, the iNAV is a reasonable sanity check.
• For a fund of foreign stocks during US hours, the iNAV is built partly from closing prices in markets that are shut, and the ETF price can legitimately differ from it.
• For bond funds, both the iNAV and the NAV rest on estimated prices.

The tax mechanism, precisely

ETFs' tax efficiency is often explained as "in-kind redemptions avoid selling." The underlying legal mechanism is a single provision of the Internal Revenue Code. Ordinarily, a corporation that distributes appreciated property to a shareholder must recognize the gain as if it had sold the property (section 311(b)). Section 852(b)(6) switches that rule off for a regulated investment company when the distribution is in redemption of its stock on the shareholder's demand. When an AP redeems a creation unit and receives securities, the fund recognizes no gain on them.

The fund also chooses which tax lots to hand over, and it hands over the ones with the lowest cost basis.

Two limits matter. The gain is deferred for the investor, not erased: you still owe tax on your own gain when you sell your ETF shares. And the mechanism only works when redemptions are in kind, so funds that create and redeem mainly in cash, which includes many bond funds and some international funds, give up much of the advantage.

What Rule 6c-11 requires you can see

Before 2019, each ETF needed its own SEC exemptive order. Rule 6c-11, adopted in September 2019 and effective December 23, 2019, replaced most of those orders with one set of conditions for ETFs organized as open-end funds. The original rule excluded unit investment trusts (SPY is one), leveraged and inverse ETFs, ETF share classes of multi-class funds and non-transparent ETFs. In October 2020 the SEC amended it so that leveraged and inverse ETFs complying with the new derivatives rule, Rule 18f-4, could rely on it too (see Leveraged and inverse ETFs: daily reset math and volatility drag).

According to the SEC's compliance guide, an ETF relying on the rule must post on its website:

• its portfolio holdings used to calculate that day's NAV, as of the prior business day's close, before regular trading opens;
• a table and line graph of premiums and discounts, plus an explanation whenever the premium or discount exceeds 2% for more than seven consecutive trading days; and
• its median bid-ask spread over the most recent 30 calendar days.

Those three items are a quick due-diligence kit. The holdings tell you what you own. The premium and discount history shows how well the arbitrage band has held, including in stressed months. The median spread tells you what a round trip has actually cost recently, which is more useful than average daily volume.

Pitfalls and misconceptions

"Low volume means I can't trade it." An ETF's real liquidity is mostly the liquidity of what it holds. A fund that trades 20,000 shares a day but holds large-cap stocks can usually absorb a bigger order, because market makers can create shares to fill it. Use a limit order, and for a large order ask your broker about working it with a market maker. Liquidity and slippage: volume, depth, spread and market impact covers the mechanics.

"A premium means the ETF is overpriced." Within the band, it may just reflect costs, or, for foreign funds, news that has not yet reached prices in a closed market.

Trading at the open. In the first minutes after 9:30 a.m. ET some holdings have not opened, so market makers widen spreads. The same applies when a large share of the basket is in a market that is closed for a holiday.

Assuming arbitrage is guaranteed. APs are not obliged to create or redeem. If they step back, as they can in a crisis or for a fund that is hard to hedge, the band can widen sharply.

Forgetting closures. Funds that fail to gather assets are sometimes liquidated. Holders are paid out in cash at NAV, which can realize a taxable gain or loss at a time you did not choose.

How the parts compare

How Finabase does it

Every ETF has a symbol page with its live quote, chart, dividend history and news. Its Holders tab can show a fund card with the issuer, asset class, expense ratio, assets under management, NAV, number of holdings, top holdings and sector and country weights, when our fund-data feed has them; for some funds the tab shows only institutional and mutual-fund holders. The sector page shows how the S&P 500's sectors are moving, a quick way to see what is driving a broad stock ETF on a given day.

Finabase does not publish an intraday indicative value, a premium and discount history or a median spread for ETFs. For those, use the fund's own website, where Rule 6c-11 requires them. The diagram on this page was drawn by Finabase Research.

Frequently asked questions

Can an individual investor create or redeem ETF shares?

No. Only authorized participants that have signed an agreement with the fund can create or redeem, and only in creation-unit blocks. Individual investors buy and sell existing shares on an exchange.

What is a creation unit?

It is the block of ETF shares that an authorized participant creates or redeems in one transaction, in exchange for the fund's published basket of securities and cash. Each fund sets its own size; the SEC uses 50,000 shares as an example.

Why does my ETF trade away from its iNAV?

Because the iNAV is only an estimate. For funds holding foreign stocks or bonds it is built partly from stale or estimated prices, and the ETF price, which reflects current trading, can be the better guide. A gap smaller than the fund's arbitrage band is also normal.

Do all ETFs get the in-kind tax benefit?

No. The benefit depends on redemptions being in kind. Funds that redeem mostly in cash must sell holdings, can realize gains and may distribute them, just like mutual funds.

What does Rule 6c-11 require ETFs to disclose?

Daily portfolio holdings before trading opens, a history of premiums and discounts to NAV (with an explanation if one exceeds 2% for more than seven trading days in a row), and the median bid-ask spread over the last 30 calendar days.

Summary

An ETF's price stays near its NAV because authorized participants can swap baskets of securities for blocks of shares, but only when the gap exceeds their costs to trade the basket, pay the fund's fee and hedge. Those costs set an arbitrage band: tiny for funds of liquid US stocks, wider for bonds and for foreign markets that are closed during US hours, and wider still in a crisis. The intraday indicative value is a rough estimate that the SEC declined to require in Rule 6c-11, because it can be stale. The tax advantage comes from section 852(b)(6), which lets a fund hand appreciated lots to a redeeming AP without recognizing the gain, and it works only for in-kind redemptions. For any specific fund, the holdings, premium and discount history and median spread that Rule 6c-11 requires on its website show how well the machine works in practice.