Redemption Mechanism

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.

BREAKING DOWN '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.