Redemption Mechanism Definition

What is a redemption mechanism?

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

Key points to remember

  • A buy-back mechanism is a method used by market makers of exchange-traded funds (ETFs) to reconcile differences between net asset values ​​and market values.
  • In the event of a valuation error, the authorized participants (AP), the brokers responsible for acquiring the securities that the ETF wishes to hold, intervene and profit from it.
  • APs profit from ETF stocks that trade at a premium or a discount, arbitrating price differences until the fund returns to its fair value.
  • Adding or subtracting ETF stocks from the market to meet demand improves efficiency, closer index tracking, and ensures ETFs are priced fairly.

How a refund mechanism works

The reimbursement mechanism is used by authorized participants (AP): the broker-dealers in charge of acquiring the securities that the ETF wants to hold. If the ETF’s objective is to track the S&P 500 Index, the AP will purchase all of its constituents in the same weighting and deliver them to the sponsor, in exchange for a block of ETF shares of equal value, at the price of their net asset value. This arrangement, known as the 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 common stocks, which means their prices fluctuate throughout the day. If the ETF suddenly experiences a resurgence in popularity, its stock price will exceed the value of its underlying securities. Conversely, market prices could fall below just value if the fund falls out of favor with investors and a sale occurs.

Important

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

When NAV and market values ​​diverge, APs can step in and capitalize on arbitration opportunities – buying a security in one market and simultaneously selling it in another to take advantage of a temporary difference in price. These moves should bring the ETF’s share price back to fair value, eliminating valuation errors and earning the AP a risk-free account. profit.

Example of reimbursement mechanism

If the ETF is in high demand and is trading at a primethe AP could sell the shares it received when it was created and make a spread between the cost of the assets it purchased for the ETF issuer and the sale price of the ETF shares. He can also enter the market and buy the underlying stocks that make up the ETF directly at lower prices, sell ETF shares in the open market at a higher price and capture the spread.

Benefits of a reimbursement mechanism

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

APs conduct all purchases and sales of securities on behalf of the ETF, bearing the trading and other costs associated with creation and redemption activity that would otherwise eat into the fund’s income. Return. Their ability to add or subtract ETF shares from the market to meet demand increases efficiency, facilitates closer index tracking, and ensures that ETFs are priced fairly and only momentarily subject to supply and demand dynamic.

Competing products such as firm mutual funds or unit investment trusts (ITU) do not appreciate this luxury. With no one behind them to create or redeem shares and manage the market price, they charge higher fees and regularly trade at noticeable premiums or discounts to their NAVs.

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