Redemption Mechanism

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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. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  5. Liquidity

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