How Do ETFs Work?

Exchange traded funds work differently than traditional mutual funds. The key point to note is that when unitholders buy or sell, they are interacting with one another on the exchange just as they would when buying or selling a stock. This is one of the primary differences between an ETF and a traditional mutual fund.

Understanding the creation and redemption process for ETFs

ETFs can offer the benefits of both index funds and conventional equities because of the process by which they are created and redeemed in the marketplace – through an "in-kind" transaction made by Designated Brokers, or market makers and the Underwriters, not the fund's individual unitholders. When the Designated Brokers want units of the iShares CDN LargeCap 60 Index Fund (XIU), for example, they assemble (either buying from the market or gathering from their inventory) each security within the S&P/TSX 60 Index in its precise weight and delivers them to the Fund. Then, in exchange for the securities, the Fund gives the Designated Brokers units of the Fund. This process works in reverse when they make a redemption.

This creation and redemption process provides the close benchmark correlation of index mutual funds together with the liquidity and transparency common to exchange-listed securities. The benefits of this 'in-kind' creation and redemption process include:

• The process provides a mechanism to keep the market ETF prices close to the value of the underlying securities.
• The process establishes an open-ended potential supply through the ability to create new units of an ETF, which translates into a high degree of liquidity.
• The process reduces the potential for generating unintended taxable distributions to unitholders that accompany cash redemptions.
• The process minimizes operating costs by eliminating most of the transfer functions of a mutual fund.

By way of comparison, consider the process for creating and redeeming shares of a traditional mutual fund. Mutual fund unitholders interact directly with the fund, exchanging shares for cash or vice versa. The fund may take cash and buy securities or conversely sell securities to raise cash. When buying shares of the mutual fund, unitholders receive the NAV priced at the end of the trading day.

The impact of fund companies dealing directly with investors for cash has a couple of important implications for the end unitholder. First, as the portfolio manager buys and sells securities to manage the cash flows they will incur trading costs. These costs are netted out of the underlying assets of the fund and thus are borne by all unitholders. Second, this trading to manage cash flows has the potential to generate capital gains – which are shared by all investors when distributions occur at year end.

Source: Barclays Global Investors Canada Limited. Used with permission. Adapted for use by Desjardins Online Brokerage.