How do ETFs work? Creation and redemption, step by step

Why an ETF’s price stays close to its net asset value (NAV), and how authorized participants create and redeem its shares, step by step.

An exchange-traded fund, or ETF, is a fund whose shares trade on a stock exchange, as a company’s stock does. An ETF can hold stocks, bonds or other assets, often those of an index such as the S&P 500. Each ETF share is an equal part of the fund. The ETF in this post holds stocks.

Investors buy and sell ETF shares with each other on the exchange. So the price of an ETF share can differ from what the fund’s stocks are worth per ETF share. Dealers called authorized participants have an agreement with the fund that lets them trade stocks for ETF shares with the fund itself. Their trades keep the price close to that value.

A fund’s net asset value is the value of its stocks and cash, less its debts, for each ETF share. For example, take a fund that holds only stocks, worth $100 for each ETF share, and has no debts. Its net asset value is $100.

Suppose buyers push the price of an ETF share on the exchange to $101. A dealer then pays $100 for the stocks that the fund holds for one ETF share and delivers them to the fund. In return, the fund gives the dealer a new ETF share, which the dealer sells on the exchange for $101. Before its costs, the dealer earns $1. Its sale adds to the ETF shares offered on the exchange, so the price falls back toward $100.

If sellers instead push the price down to $99, the dealer does the reverse. It buys an ETF share on the exchange for $99 and returns it to the fund. The fund cancels the ETF share and gives the dealer the stocks it held for that ETF share, which the dealer sells for $100. Again the dealer earns $1 before its costs. Its purchase adds to the demand for ETF shares, so the price rises back toward $100.

The picture shows the two trades for a fund of three stocks. Use the Next button to go through the six steps.

Step 1 of 6

The net asset value is calculated at each day’s close

At the end of every trading day, the fund calculates its net asset value:

\[\begin{aligned}&\text{net asset value}\\&= \frac{\text{assets} - \text{debts}}{\text{number of ETF shares}}.\end{aligned}\]

The assets are any cash and the stocks, usually valued at that day’s closing prices. The debts include fees the fund has not yet paid. A fund with stocks and cash worth $10 million, no debts and 100,000 ETF shares has a net asset value of $100 per ETF share. Fund websites publish this number every day as the NAV.

During the trading day the stocks’ prices keep changing, so the fund’s value per ETF share changes too. Dealers compare the price of an ETF share with an estimate of the net asset value from the stocks’ current prices. The net asset value published at the last close uses prices that have changed since.

An ETF share can trade at a premium or a discount

The price of an ETF share moves all day with the prices of the stocks and with the demand for ETF shares. When the price is above the net asset value, the ETF share trades at a premium. When the price is below the net asset value, the ETF share trades at a discount. At a price of $101 and a net asset value of $100, the premium is $1, or 1% of the net asset value.

Investors in a mutual fund trade with the fund itself, once a day, at the net asset value. So a mutual fund’s shares have no premium or discount.

Authorized participants create and redeem ETF shares in large blocks

The dealers are large banks and trading firms. Their agreement with the fund lets them create new ETF shares by delivering stocks, and redeem ETF shares by returning them for stocks. The dealers trade with the fund in large blocks, which funds call creation units. For example, a block can be 50,000 ETF shares. Each day the fund publishes the basket, the list of stocks it accepts for a block. Here the basket holds the stocks in the same proportions as the fund does. Some ETFs also accept cash, or a basket that differs from the fund. Because stocks change hands instead of cash, these trades are called in kind.

Both trades take place at the value of the stocks. So a creation adds stocks and ETF shares in the same proportion, and a redemption removes them in the same proportion. Either way, the net asset value stays the same. In the picture, stocks worth $10,000 for 100 ETF shares become stocks worth $10,100 for 101 ETF shares, still $100 per ETF share.

A dealer earns the difference between the price of an ETF share and the value of the fund’s stocks per ETF share, less the dealer’s own costs. The dealer pays to trade the stocks, and the fund charges it a fee for each block. So dealers trade only when the difference is larger than their costs, and their trades narrow it.

Why ETFs often distribute fewer capital gains

Under U.S. tax rules, investors holding funds in taxable accounts can owe tax even when they have not sold any fund shares. The tax can arise from profits that the fund pays out to them.

Suppose a fund bought company stocks for $60 several years ago and sells them for $100. The fund has made a $40 capital gain. Funds normally pay their gains from stock sales, after deducting losses, to their investors. These payments are called capital-gains distributions. Investors can owe tax on the payments even if they keep all their fund shares.

When an investor withdraws money from a mutual fund, the fund normally pays that investor cash. To raise the cash, it may sell company stocks. If those sales produce gains, the investors who remain in the fund can receive a taxable distribution.

When an investor sells ETF shares on the exchange, the buyer provides the cash. The ETF does not need to sell company stocks to pay the departing investor.

An authorized participant can also return ETF shares directly to the fund. The ETF can give the dealer company stocks instead of cash. Under U.S. tax rules, that transfer generally creates no taxable gain for the fund, even if the stocks are worth more than the fund paid for them. There is therefore no gain from that transfer for the fund to distribute.

These arrangements help ETFs avoid some taxable distributions, allowing investors to postpone more of their capital-gains tax. ETFs can still distribute gains from other stock sales. Investors may also owe tax on dividends and on their own gain when they sell their ETF shares.

An ETF costs its expense ratio and the bid-ask spread

The fund charges a yearly fee, the expense ratio, as a percentage of its assets. A fee of 0.20% a year costs 20 cents a year for each $100 invested. The fund takes the fee from its assets a little every day, so investors pay it through a lower net asset value.

Buying and selling ETF shares also costs the bid-ask spread. The bid is the highest price that a buyer offers to pay, and the ask is the lowest price that a seller offers to accept. If the bid is $59.50 and the ask is $60, you buy at $60 and sell at $59.50. So buying an ETF share and selling it at once costs the spread of 50 cents. Your broker may also charge a commission for each trade.

Limitations

The stocks’ prices stay the same in the picture. In a real fund they change all day, and the price of an ETF share changes with them.

Some funds hold stocks whose exchange is closed while the ETF trades. A fund listed in New York that holds Japanese stocks trades after the Tokyo exchange has closed. The stocks’ last prices are then hours old, while the price of an ETF share also moves with the news since then. So the premium or discount against the stocks’ last value can be larger. The fund may also adjust that value for such news.

The difference can grow when trading is costly. In a financial crisis, the stocks or bonds a fund holds can become costly to trade, and the dealers’ costs rise. The price can then move further from the value of the stocks before dealers trade.

Other exchange-traded products work differently. Exchange-traded notes, for example, are a bank’s promise to pay an index’s return, and they hold no stocks.

Conclusion

The takeaway is that an investor who buys an ETF share pays close to what its part of the fund’s stocks is worth, because the dealers’ trades narrow any difference larger than their costs. The difference can be wider when the stocks are costly to trade or their exchange is closed.

Read next

• What do you own in emerging markets? How the companies held by one emerging-markets ETF changed from 2007 to 2026.
• How smart are smart beta ETFs? What ETFs that choose their stocks by rules returned against their benchmarks.
• Does announcing trades still hurt index investors? What stocks entering and leaving an index returned before index funds traded them.

Disclaimer: an explanation for teaching purposes, not investment advice. The fund, its three stocks and the prices in the picture are made up.

Sources: U.S. Securities and Exchange Commission, Office of Investor Education and Advocacy, Updated Investor Bulletin: Exchange-Traded Funds (ETFs), 23 February 2023. The bulletin describes the net asset value, the authorized participants, the creation units of 50,000 ETF shares, the trades in kind, the premiums and discounts, the taxes and the bid-ask spread example.