NEW YORK ( TheStreet) -- The prevalence of Exchange-Traded Funds (ETFs) will impact all investors, whether they know it or not. But investors who understand how ETFs work -- and how Wall Street uses them -- are better prepared to make rational investment decisions. Below you will find an introduction to ETFs, the first of a four-part series which also touches upon: the impact of ETF arbitrage, ETFs and stock market correlation and the future of ETF investing.
What Is an ETF?An Exchange-Traded Fund (ETF) is a security that tracks an index or basket of securities and is traded on an exchange. ETFs are traded just like stocks, experiencing price fluctuations throughout the day. The underlying assets that ETFs track can include stocks, bonds, commodities, and currencies.
How Are ETFs Created? The Creation/Redemption ProcessAn ETF sponsor first creates an ETF fund, which an Authorized Participant (AP) can use to create or redeem shares. An AP, usually a large financial institution, forms creation units, which are baskets of stocks holding 50,000 shares or more. The AP can then exchange the creation units for ETF shares with the ETF fund. Since this trade is done in-kind (securities are traded for securities), the transaction is not subject to a capital gains tax.
In the diagram above: ETF shares and creation units flow between the fund and the authorized participant; ETF shares and cash flow between the authorized participant and investors; cash and securities flow between the authorized participant and the capital markets. Once created, the AP can sell ETF shares to investors on the open market. To redeem ETF shares, the AP exchanges the ETF shares for the basket of stocks. Since the AP can create or redeem shares at any point throughout the day, ETF trading is also associated with high-frequency trading.