Some people are happy to simply use a range of devices like wrist watches and computers and trust that things will work out. Others want to know the inner workings of the technology they use, and understand how it was built. If you fall into the latter category and as an investor have an interest in the benefits that exchange-traded funds (ETFs) offer, you'll definitely be interested in the story behind their construction.

ETF Creation
The creation and redemption process for ETF shares is almost the exact opposite of that of mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which then uses that cash to purchase securities and in turn issue additional shares of the fund. When investors wish to redeem their mutual fund shares, the shares are returned to the mutual fund company in exchange for cash. The creation of an ETF, however, does not involve cash.

The process begins when a prospective ETF manager (known as a sponsor) files a plan with the SEC to create an ETF. Once the plan is approved, the sponsor forms an agreement with an authorized participant, generally a market maker, specialist or large institutional investor, who is empowered to create or redeem ETF shares. (In some cases, the authorized participant and the sponsor are the same).

The authorized participant borrows shares of stock, often from a pension fund, and places those shares in a trust, and uses them to form creation units of the ETF. Creation units are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares is what's commonly designated as one creation unit of a given ETF. Then, the trust provides shares of the ETF - which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units) - to the authorized participant. Because this transaction is an in-kind trade - that is, securities are traded for securities (the authorized participant provides shares of stock to the trust and the trust in turn provides ETF shares to the authorized participant) and no cash changes hands - there are no tax implications. Once the authorized participant receives the ETF shares, the shares are then sold to the public on the open market just like shares of stock.

When ETF shares are bought and sold on the open market, the underlying securities that were borrowed to form the creation units remain in the trust account. The trust generally has little activity beyond paying dividends from the stock held in the trust to the ETF owners and providing administrative oversight because the creation units are not impacted by the transactions that take place on the market when ETF shares are bought and sold.

Redemptions
When investors want to sell their ETF holdings, they can do so by one of two methods. The first is to sell the shares on the open market. This is generally the option chosen by most individual investors. The second option is to gather enough shares of the ETF to form a creation unit and then exchange the creation unit for the underlying securities. This option is generally only available to institutional investors due to the large number of shares required to form a creation unit. When these investors redeem, the creation unit is destroyed and the securities are turned over to the redeemer. The beauty of this option is in its tax implications for the portfolio.
We can see these tax implications best by comparing the ETF redemption to that of a mutual fund redemption. When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by tax burden because to redeem the shares, the mutual fund may have to sell the securities it holds, realizing the capital gain, which is subject to tax. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis. So even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains.

ETFs minimize this scenario by paying large redemptions with shares of stock. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer. This increases the cost basis of the ETF's overall holdings, minimizing capital gains for the ETF. It doesn't matter to the redeemer that the shares it receives have the lowest cost basis because the redeemer's tax liability is based on the purchase price it paid for the ETF shares, not the fund's cost basis. When the redeemer sells the shares of stock on the open market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios.