Redemption Mechanism

AAA

DEFINITION of 'Redemption Mechanism '

Refers to how market makers of exchange traded funds (ETF) can reconcile the differences between net asset value (NAV) and market values when shares of the ETFs are bought and sold. The market maker can arbitrage the ETF shares with the shares that make up the underlying portfolio, or by buying or redeeming lots of the ETF shares. This structure causes ETFs to be treated as "in kind" transactions where investors only pay capital gains like with stocks, as opposed to other fees associated with mutual funds.

INVESTOPEDIA EXPLAINS 'Redemption Mechanism '

This mechanism allows ETFs to be unique from mutual funds or unit investment trusts. Mutual funds can only be bought or sold for the NAV, which is calculated at the end of the trading day. Unit investment trusts can trade more fluidly, however the structure allows them to trade away from the NAV of the underlying portfolio. The redemption mechanism of ETFs causes neither of these problems to occur. ETFs trade liquidly on the exchange, and do not stray far from the NAV, because the market makers can so easily arbitrage the difference.

RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Redemption

    The return of an investor's principal in a fixed income security, ...
  3. Net Asset Value - NAV

    A mutual fund's price per share or exchange-traded fund's (ETF) ...
  4. Liquidity

    1. The degree to which an asset or security can be bought or ...
  5. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  6. Market Maker

    A broker-dealer firm that accepts the risk of holding a certain ...
RELATED FAQS
  1. What strategies are used in a redemption mechanism?

    Redemption mechanism strategies are deployed by market makers to ensure the price of an exchange-traded fund, or ETF, does ... Read Full Answer >>
  2. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  5. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  6. What action is the SEC likely to take on 12b-1 fees?

    The Securities and Exchange Commission (SEC) may take action to impose greater regulation on how 12b-1 fees are used, or ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    4 Ways To Use ETFs In Your Portfolio

    To take full advantage of these vehicles, you need to know how they can fulfill certain strategies.
  2. Options & Futures

    The Benefits Of ETF Investing

    Exchange-traded funds provide unique opportunities for investors. Find out how.
  3. Mutual Funds & ETFs

    Introduction To Exchange-Traded Funds

    Get into ETFs and enjoy the benefits of a mutual fund with the flexibility of a stock.
  4. Retirement

    Electronic Trading Tutorial

    Learn about the systems that run the market. Topics include market makers, specialists, SuperDOT, ECNs, SOES, Level I, II, and III Access, and more.
  5. Mutual Funds & ETFs

    The Top 3 ETFs For Investing in Agriculture

    Learn about some the best available exchange-traded funds for profiting from exposure to the agricultural sector through stocks and futures.
  6. Mutual Funds & ETFs

    The Top 3 ETFs For Investing in the Russell 200 Index

    Learn about three ETFs that track the Russell Top 200 Index and how these ETFs have a very high correlation with the S&P 500 index.
  7. Mutual Funds & ETFs

    The Top 3 ETFs For Investing in Hong Kong

    Discover information and analysis of three exchange traded funds that investors can use to access potential profits from investing in Hong Kong.
  8. Mutual Funds & ETFs

    The Top 3 ETFs For Investing in Canada

    Learn specific information about three of the most popular and best performing ETFs that offer exposure to Canadian equity markets for U.S. investors.
  9. Mutual Funds & ETFs

    Top ETFs For Investing in Greece

    Find out if it's time to add the GREK ETF -- the only major Greece-centric exchange-traded fund in the world -- as a risk/reward play to your portfolio.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard International Stock

    Discover how the Vanguard Total International Stock ETF is managed, and learn which investors may find it suitable as part of a diversified portfolio.

You May Also Like

Hot Definitions
  1. Topless Meeting

    A meeting in which participants are not allowed to use laptops. A topless meeting organizer can also ban the use of smartphones, ...
  2. Hedging Transaction

    A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. Hedging ...
  3. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  4. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  5. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  6. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!