Definition
ETF Creation/Redemption
Creation and redemption is the primary-market mechanism by which authorised participants exchange a basket of underlying securities (or cash) for new ETF units, or hand back units for the basket, keeping the ETF price aligned with its NAV.
In India, an authorised participant delivers the day's creation basket of constituent stocks (an in-kind transfer) to the fund house and receives a block of new ETF units, or does the reverse to redeem. This continuous expansion and contraction of supply is what lets ETFs trade close to fair value.
When the ETF's market price drifts above its iNAV, APs create units and sell them, pushing the price down; when it trades at a discount, they redeem, supporting the price. This arbitrage loop is the engine that controls tracking error and premium/discount to NAV, distinguishing ETFs from closed-end funds.
Related terms
- Authorised ParticipantAn authorised participant is a large institutional intermediary contracted with an ETF issuer that has the exclusive right to create and redeem ETF units directly with the fund in large blocks.
- Premium/Discount to NAVAn ETF trades at a premium when its market price is above its net asset value and at a discount when below, reflecting temporary imbalances between on-screen supply and demand and fair value.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.