7956 / How do ETFs operate?

The SEC described the operation of ETFs as follows:

Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares (‘ETF shares’) at net asset value (’NAV’). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks called “creation units.” A financial institution that purchases a creation unit of ETF shares first deposits with the ETF a “purchase basket” of certain securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets. The basket generally reflects the contents of the ETF’s portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit. After purchasing a creation unit, the financial institution may hold the ETF shares, or sell some or all in secondary market transactions.¹

ETFs must register offerings and sales of shares under the securities laws, and, “as with any listed security, investors may trade ETF shares at market prices. ETF shares purchased in secondary market transactions are not redeemable from the ETF except in creation units.”²

---

Planning Point: The SEC has released a new rule designed to allow ETFs to be marketed to the public without first applying for individual exemptive relief. The new rule 6c-11 is available to ETFs organized as open-end funds so long as the ETF satisfies certain conditions. First, the ETF must provide daily portfolio transparency on its website. The ETF must also disclose certain historical information on its website, including information about premiums and discounts, and bid-ask spread information. If the ETF adopts written policies and procedures providing detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, the ETF can use baskets that do not reflect the pro rata representation of the ETF’s portfolio or that differ from the original basket. ETFs have a one-year transition period to comply with the new rule, after which all exemptive relief will be rescinded for ETFs permitted to rely upon the rule.

---

Redemption of ETF shares mirrors the purchase process:

The financial institution acquires (through purchases . . . the number of ETF shares that comprise a creation unit, and redeems the creation unit from the ETF in exchange for a “redemption basket” of securities and other assets. An investor holding fewer ETF shares than the amount needed to constitute a creation unit (most retail investors) may dispose of those ETF shares by selling them on the secondary market. The investor receives market price for the ETF shares, which may be higher or lower than the NAV of the shares, and pays customary brokerage commissions on the sale.³