What Is a Redemption Mechanism?

A redemption mechanism is a method used by market makers of exchange-traded funds (ETF) to reconcile the differences between net asset values (NAV) and market values. This process, also referred to as the ETF creation and redemption mechanism, helps to prevents shares of an ETF trading at a discount or premium, keeping it in line with its underlying NAV, the fair value of a single share of the fund.

Key Takeaways

  • A redemption mechanism is a method used by market makers of exchange-traded funds (ETF) to reconcile the differences between net asset values and market values.
  • When mispricing occurs, authorized participants (APs), the broker-dealers responsible for acquiring the securities that the ETF wants to hold, step in and take advantage.
  • APs profit from ETF shares trading at a premium or discount, arbitraging price differences until the fund is restored back to its fair value.
  • Adding or subtracting ETF shares from the market to match demand boosts efficiency, tighter tracking of indexes and ensures that ETFs are priced fairly.

How a Redemption Mechanism Works

The redemption mechanism is used by authorized participants (APs): the broker-dealers responsible for acquiring the securities that the ETF wants to hold. If the ETF’s aim is to track the S&P 500 index, the AP will purchase all its constituents in the same weight and deliver them to the sponsor, in exchange for a block of equally valued ETF shares, priced at their NAV. This arrangement, known as a creation unit, gives the ETF provider the securities it needs to track the index and the AP a block of ETF shares to resell at a profit.

ETFs trade like regular stocks, meaning that their prices fluctuate throughout the day. If the ETF suddenly experiences a surge in popularity, its share price will rise above the value of its underlying securities. Conversely, market prices could fall below fair value if the fund falls out of favor with investors and a sell-off occurs.

Important

When an ETF’s share price strays from the fair value of its portfolio of securities, authorized participants (APs) will simultaneously buy and sell to make themselves a profit.

When NAV and market values diverge, APs can intervene and capitalize on arbitrage opportunities — the act of buying a security in one market and simultaneously selling it in another to cash in on a temporary difference in prices. These measures should drive the ETF's share price back toward fair value, eliminating mispricing, and earn the AP a risk-free profit.

Example of a Redemption Mechanism

If the ETF is in high demand and trades at a premium, the AP could sell the shares it received during its creation and make a spread between the cost of the assets it bought for the ETF issuer and the selling price from the ETF shares. It may also go into the market and buy the underlying shares that compose the ETF directly at lower prices, sell ETF shares on the open market at a higher price, and capture the spread.

Benefits of a Redemption Mechanism

The redemption mechanism process is the driving force behind many of the advantages associated with ETFs, helping to keep them cheap, transparent, and tax-efficient among other things.

APs do all of the buying and selling of securities on the ETF's behalf, stomaching the trading costs and other fees associated with creation and redemption activity that would otherwise eat into the fund's returns. Their ability to add or subtract ETF shares from the market to match demand boosts efficiency, facilitates tighter tracking of indexes, and ensures that ETFs are priced fairly and only momentarily subject to supply and demand dynamics.

Competing products such as closed-end mutual funds or unit investment trusts (UITs) don’t enjoy this luxury. Not having anyone behind them to create or redeem shares and manage the market price results in them imposing higher charges and regularly trading at notable premiums or discounts to their NAVs.