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This is the second episode in a three-part series on ETFs. In our last episode, we focused on how an ETF comes to market. This episode is about what happens after that. Most people don’t think about these mechanics until something feels off, but understanding how ETFs work under the hood makes it easier to identify good opportunities as well as situations you’d rather avoid.
The three things that you will understand at the end of this episode are: who authorized participants are, how ETF shares are created and redeemed, and why the trading price usually stays close to the value of what the fund owns.
Once those pieces click, the benefits of the ETF structure—and the caveats—start to make a lot more sense.
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Authorized Participants: The Bridge Between the ETF and Its Holdings
ETFs operate in two markets at the same time.
The world you know is where ETF trades take place on an exchange. You can buy it at 10:07 a.m., sell it at 1:12 p.m., and place a limit order if you want to control your price. That’s known as the secondary market—investors trading ETF shares with other investors.
If you only know that first world, ETFs feel like “mutual funds that trade like stocks.” That’s true on the surface, but it’s not what makes them special.
The other market is one you don’t see. It’s called the primary market, and it’s a direct channel between the ETF and a small group of large institutions known as authorized participants or APs.
You and I don’t interact with the authorized participants—we only trade ETFs on an exchange. The AP has a standing agreement with an ETF to create and redeem shares directly with the fund. Said differently, the AP can swap a basket of securities for a large block of ETF shares, or swap ETF shares back for the underlying securities.
The AP will do this because they can profit when the ETF’s trading price and the value of its holdings drift apart. That profit motive is usually good for retail investors, because it’s the reason ETF prices tend to stay close to the value of the underlying holdings.
NAV vs. Market Price: Why ETF Prices Usually Stay Close to Value
Let me explain.
First, NAV stands for net asset value. It’s the value of the ETF’s underlying holdings divided by the number of shares outstanding. Mutual funds also calculate NAV—typically once per day—and that’s the price everyone gets when they buy or sell. One price after the close.
The market price is the live price of the ETF share on an exchange. It moves throughout the day as buyers and sellers trade.
Because of that, the market price and NAV won’t match perfectly at every moment. When the ETF trades above the value of its holdings, it’s called a premium. When it trades below, it’s called a discount.
This is where authorized participants come into play. When the premium or discount gets big enough to matter, APs have an incentive to step in and close the gap using creation or redemption.
Creation and Redemption: How ETFs Expand and Contract
So here’s what that looks like.
Everyday, ETFs publish a “recipe” for what a creation unit looks like. In many ETFs–especially plain-vanilla index ETFs–that recipe is a basket of securities that closely matches what the ETF holds.
The basket might include hundreds of stocks in specific quantities, plus maybe a little bit of cash for rounding and expenses.
Let me walk you through a simple example of both:
Creation: what happens when investors are buying the ETF
Imagine an ETF is getting a lot of buyer interest. Investors are hitting the “buy” button, and the ETF’s market price starts to creep a little higher than the value of its holdings.
In that environment, here’s what can happen:
- The ETF is trading at a slight premium because demand is strong.
- An AP can buy the underlying basket of securities in the market.
- The AP delivers that basket to the ETF.
- The ETF issues the AP a creation unit of new ETF shares.
- The AP can then sell those ETF shares into the market to meet investor demand.
- That process increases the supply of ETF shares available to investors.
So instead of the price just rising because people want the ETF, new shares come into the system to meet demand and bring market price and NAV closer together.
Redemption: what happens when investors are selling the ETF
Now flip it.
Imagine investors are selling the ETF heavily, and the trading price starts to drift a little below the value of the underlying holdings.
In that case:
- The ETF is trading at a discount because selling pressure is strong.
- An AP can buy ETF shares in the market at that discounted price.
- The AP delivers a creation unit of ETF shares back to the ETF.
- The ETF hands back the underlying basket of securities.
- The AP can sell those securities or use them to hedge.
That process reduces the number of ETF shares in circulation. So supply shrinks when demand shrinks.
The creation/redemption process is one reason ETFs can handle big inflows and outflows without forcing the portfolio manager to constantly buy and sell just to accommodate investor activity.
It’s also where a lot of the tax story starts.
In-Kind vs. Cash: Why the Tax Results Can Be Different
When people talk about ETFs being tax-efficient, they’re usually talking about in-kind creations and redemptions—meaning baskets of securities move in and out, not cash.
Here’s why it matters.
With a traditional mutual fund, redemptions often mean the fund has to raise cash, which can require selling securities. If those sales realize gains, the fund may distribute those gains to shareholders—even to the people who didn’t sell.
With an ETF using in-kind redemptions, the fund can meet redemptions by handing securities out instead of selling them. Over time, that can help reduce embedded gains inside the portfolio. In a taxable account, that often means fewer capital gains distributions.
Now, a common misconception is that all ETFs experience better tax efficiency than mutual funds, but this isn’t always true. Particularly for ETFs that rely more on cash creations and redemptions because building a clean basket is harder or less efficient—certain bond markets, some international exposures, and definitely some active strategies.
There are some other innovations like heartbeat trades and ETF share classes of a mutual fund, but I think might be beyond the scope of this episode. I’ll find another time to talk about those, but I did have an in-depth conversation with Marlena Lee on some of these things back in Episode 232: The Latest Innovations in ETFs and Mutual Funds if you want to dig in more right now.
These Mechanics Mean for You (And What They Don’t)
Fewer surprise capital gains distributions
In a taxable account, one of the most frustrating surprises is getting a capital gains distribution even when you didn’t sell anything. As we just covered, mutual funds may have to sell securities to meet redemptions; ETFs can often deliver securities in kind. Over time, that can reduce embedded gains inside the fund and lower the odds of capital gains distributions—especially for broad, liquid strategies. It’s not a guarantee, but it’s a real structural advantage.
More control over your trading price
ETFs trade on an exchange, so you can buy and sell during the market day and use limit orders to control your price. That doesn’t mean you should trade more. It means you have more control when you do need to trade—rebalancing, raising cash, or putting money to work.
Transparency that helps the market price the ETF
Most ETFs disclose holdings regularly. That makes it easier for market makers and APs to manage risk and quote tighter prices, which supports a smoother trading experience for investors. The transparency also offers some interesting lines of sight into less liquid markets that have ETFs on the secondary market.
None of this means ETFs are automatically better. If an ETF relies heavily on cash creations/redemptions, or holds harder-to-trade assets, it may not get the same tax or trading benefits. Some ETFs will still distribute capital gains. Some will trade with wider spreads. And because ETFs trade like stocks, execution matters—careless trading can turn a good product into a frustrating experience.
So the right takeaway isn’t “ETFs are always better.” But these mechanics explain when ETFs tend to be more tax-friendly and cheaper to trade—and when they won’t be.
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