Understanding Exchange-Traded Funds: How ETFs Work

Abstract

The objective of this paper is to provide an in-depth explanation of the unique structure of ETFs and examine the question of where investors access liquidity in ETFs. We discuss how ETFs are created and by whom and how ETFs trade. We provide detailed explanations of the regulatory framework for ETFs and the clearing and settlement process by which ETF shares are created and redeemed in the U.S. Do investors primarily use the ETF creation/redemption mechanism or do they trade existing ETF shares with another investor on the secondary market? In the first case, creations and redemptions generate trading in the underlying securities; in the latter case, only ETF shares trade hands. For the 18-month period Jan. 2013 to June 2014, we find that investors made far greater use of the secondary market. These results hold up even for narrower asset classes such as, domestic small-cap equity, emerging markets equity and bond, and domestic high-yield bond. On average, daily aggregate ETF secondary market transactions were 90 percent of total primary and secondary market activity in ETFs and creations and redemptions accounted for only 10 percent. In addition, we find that the vast majority of ETFs do not have any creations or redemptions on any given day across all types of asset classes. These results help put into perspective questions regarding the role ETF creation and redemption activity may play in the markets for equities and bonds that ETFs hold in their portfolios.