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Whenever we want to buy or sell ETF units we can easily do it using our brokerage account. And we are not affected by what goes behind the scene. But, ETF units are created/redeemed and there are multiple market participants involved in this process. In this article, we will look into the process of ETF unit creation and how all involved stakeholders interact with each other for the seamless working of ETFs on stock exchanges. Without further ado, let's begin!
In stocks, the total number of shares is constant (unless there is a new issue or buyback). All the participants can buy and sell shares, but no one can create or destroy shares. However, in ETFs, new units are constantly pushed into circulation (creation) or pulled out of circulation (redemption). And these new units are created or redeemed in a predefined lot size called a creation unit.
In our previous article, we noted that you can buy or sell an ETF at NAV directly through AMC. But it can only be done in predefined lot sizes (creation units) that tend to be typically large and hence is only viable for institutional or HNI investors.
A creation unit is a block of ETF shares. The creation unit size is predefined by the ETF issuer. For example, the creation unit of Nippon India Nifty Pharma ETF is 75,000. This means that if you have 75,000 units of this ETF, you can directly sell them to Nippon India at the NAV. If you want to buy directly from the AMC, you will need to buy in lot sizes of 75,000 units. Based on the NAV at the time of writing this, this works out to be roughly ₹10 lac.
ETFs can be created/redeemed only in creation unit size. The bulk of this creation and redemption is done by Authorized Participants (APs). The diagram below shows the process:
Unlike large investors, Authorized participants create/redeem units in exchange for Portfolio Deposits which are nothing but the baskets of underlying securities held by the ETF in the same proportion.
For example, consider Nifty Bees ETF which tracks the Nifty 50 index. AP will buy shares of all the Nifty 50 constituents in the exact same weights as the index, then deliver those shares to the ETF issuer. In exchange, the issuer gives AP a block (creation unit or multiple of it) of ETF units. AP now has an inventory of new ETF units that it can “circulate” on exchange.
The process can also work in reverse. AP can remove ETF units from the market by purchasing enough units to form a creation unit and then delivering those units to the ETF issuer in exchange for an underlying basket of securities.
This process is very important in the efficient pricing of ETFs. We will learn more about this in our next article.
The creation unit of an ETF is typically decided by the ETF issuer and is based on various factors, including the underlying assets of the ETF and the liquidity of those assets.
No, individual investors cannot create or redeem ETF units directly. They must buy or sell shares on the secondary market through a brokerage account.