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To take your ETF knowledge to the next level, let's take a brief look at how ETF shares are created and the role of authorized participants — who are in charge of acquiring the securities an ETF wants to hold. Here are the mechanics of the process known as creation and redemption:
- An ETF provider or sponsor uses authorized participants (APs) to create ETF shares. For example, if a fund is designed to track the S&P 500 index, the AP buys all the stocks in the index in identical weights. The AP then delivers the shares to the ETF provider. In return, the AP receives a "creation unit" – a block of equally valued ETF shares.
- APs are typically large financial institutions (such as banks), market makers or specialists. They do most of the buying and selling for ETFs. When there is buying demand (the ETF share price trades at a premium to its NAV), APs create new shares. When there is selling demand (the ETF share price trades at a discount to its NAV), APs process redemptions.
- The creation/redemption process is what effectively keeps the price of an ETF's shares trading aligned with its underlying NAV.
- Individual stocks and mutual funds do not use authorized participants.
Remember, there are risks and benefits associated with any investment. It's a good idea to weigh both the risks and benefits when determining if any type of investment is right for you.
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