TL;DR: An exchange-traded fund is two markets glued together. On the exchange, you and I trade ETF shares like a stock. Behind the scenes, a small group of broker-dealers called authorized participants swap giant baskets of the fund’s underlying securities for ETF shares (and back) directly with the fund. That in-kind swap is what keeps the market price glued to net asset value, what makes ETFs unusually tax-efficient, and what occasionally breaks in a stressed market.
Two markets, not one
When you buy 100 shares of the Vanguard S&P 500 ETF (VOO), you’re trading in the secondary market. Someone else is on the other side of your order. No new shares are created; nothing happens inside the fund. Every ETF you can buy on your brokerage app trades this way.
The primary market is where new ETF shares are born and old ones destroyed. In this market, the only participants are the fund itself and a small circle of authorized participants (APs) — typically the largest broker-dealers and market makers (firms like Citadel Securities, Virtu, JPMorgan, Goldman Sachs, and Bank of America). APs sign a legal agreement with the fund’s sponsor that gives them the exclusive right to create and redeem ETF shares.
You never interact with the primary market. But without it, ETFs wouldn’t work the way they do.
What an authorized participant actually does
An AP is not a fund manager. It doesn’t decide what the ETF holds. It’s a plumbing firm — its job is to keep the ETF’s exchange price close to the underlying value of what the fund owns, and to make a small profit doing it.
Each morning before the market opens, the ETF sponsor publishes two things: the fund’s exact holdings (share counts and cash) and the creation basket — the list of securities an AP must deliver to receive new ETF shares. The basket usually mirrors the ETF’s portfolio; for large index ETFs it’s essentially a scaled slice of the index.
APs work in fixed lot sizes called creation units. A creation unit is a big block of ETF shares — commonly 50,000 shares, though the exact number varies by fund. At a $600 share price, that’s a $30 million clip. This is why individual investors never touch the primary market: the minimum ticket size is institutional.
The creation flow, step by step
Say the market opens and demand for VOO is heavy. Buyers push the ETF’s price on the exchange to $601.20 while the underlying S&P 500 stocks — priced in real time — are worth $600.50 per ETF share. That $0.70 gap is a premium to net asset value (NAV). An AP sees a risk-free arbitrage:
- Buy the basket. The AP buys the exact list of S&P 500 stocks that the fund requires — say, 50,000 shares worth of them — for $30,025,000.
- Deliver in-kind. The AP hands that basket of stocks to the ETF sponsor.
- Receive ETF shares. The sponsor issues 50,000 brand-new VOO shares to the AP.
- Sell into the premium. The AP sells those 50,000 shares on the exchange at $601.20, collecting $30,060,000.
Net: roughly $35,000 profit before fees, minus transaction costs and hedging. More importantly, the extra supply pushes the exchange price back down toward NAV. If demand persists, the AP does it again. The arbitrage window closes as fast as it opened.
Redemption is the mirror image. If VOO trades at a discount to NAV, the AP buys ETF shares on the exchange, hands them to the sponsor, and receives the underlying stocks — which it then sells for more than it paid. Discount closes.
Why “in-kind” is the whole game
Two features of the ETF wrapper follow directly from the in-kind mechanism, and both are structural — they aren’t marketing.
Tax efficiency. When a mutual fund sees redemptions, it usually has to sell stocks for cash, realize capital gains, and distribute those gains pro-rata to remaining shareholders — who owe taxes on gains they didn’t ask for. An ETF, redeeming in-kind, doesn’t sell anything. It just hands appreciated stock to the AP. No sale, no realized gain, no distribution. The sponsor can even use redemptions to flush out its lowest-cost-basis lots first, further reducing future capital gains. This is why most broad-market equity ETFs have gone years without paying a taxable capital-gain distribution.
Price alignment. Because the arbitrage is available to any AP any time the market is open, ETF prices track NAV closely most of the time. For a heavily-traded fund like VOO or SPY, premiums and discounts typically sit within a few basis points of NAV throughout the day.
A worked example: SPY
The SPDR S&P 500 ETF Trust (SPY) launched on January 22, 1993 as the first US ETF and — until Vanguard’s VOO overtook it in early 2025 — was the largest ETF in the world. It held over $600 billion in assets as of February 2025 with a gross expense ratio of 0.0945%. Structurally it’s a unit investment trust, which is slightly different from newer ETFs, but the creation/redemption mechanism is the same.
SPY’s creation unit is 50,000 shares. At $650 per share, that’s a $32.5 million block. On a typical trading day, dozens of creation units are created or redeemed as APs balance intraday flow. On a heavy day — say, after a Fed decision or a big index rebalance — hundreds are.
Top US ETF issuers by market share
| Issuer | US ETF market share | Well-known funds |
|---|---|---|
| BlackRock (iShares) | 29.5% | IVV, AGG, EFA, IEMG |
| Vanguard | 28.7% | VOO, VTI, BND, VXUS |
| State Street Global Advisors | 13.4% | SPY, GLD, XLF, DIA |
| Invesco | 5.0% | QQQ, RSP |
| Charles Schwab | 4.0% | SCHB, SCHD, SCHX |
How the creation/redemption plumbing looks
How big the US ETF industry actually is
Where the mechanism strains: bond ETFs under stress
The arbitrage story assumes an AP can always price and trade the underlying basket. For a large-cap equity ETF, that’s true every second of the trading day. For a bond ETF that owns hundreds of thinly-traded corporate bonds, it’s a different picture.
In late March 2020, at the peak of pandemic-era stress, several large investment-grade and high-yield bond ETFs traded at discounts of 4% to 6% to their stated NAVs — an unusually wide gap. Two forces were at work. Corporate bond dealers were struggling to find buyers, so quoted NAV was itself stale and probably optimistic. And APs, facing wide bid-ask spreads and balance-sheet limits, were reluctant to arbitrage the gap aggressively.
Interestingly, many analysts argued the ETF price was actually the truer signal of where bonds could be transacted in real time — and the “discount” was more accurately a reflection of stale NAV. The Federal Reserve’s announcement that it would buy corporate bond ETFs closed most of the discounts within days. The episode became a live case study in how the AP model performs when underlying liquidity dries up.
Related concepts to learn next
- In-kind vs cash creation. Some ETFs (particularly international, fixed-income, and thematic funds) use cash-based or hybrid creation instead of pure in-kind. This is more operationally convenient but sacrifices some of the tax-efficiency edge.
- Custom baskets. The SEC’s 2019 ETF rule modernization made it easier for sponsors to negotiate different baskets with different APs on the same day, giving portfolio managers more flexibility to shape holdings without triggering taxable sales.
- Actively-managed and semi-transparent ETFs. The 2019 rule also enabled ETFs that don’t disclose their exact holdings daily. Since the creation/redemption mechanism requires APs to know what’s in the basket, semi-transparent ETFs use proxy baskets that track the actual portfolio without revealing it in full.
- Premium/discount monitoring. Every ETF publishes historical premium/discount data on the sponsor’s website. Persistent, one-sided premiums or discounts are a red flag — usually a sign of illiquid underlyings or a broken AP relationship.
Sources
- Exchange-traded fund — Wikipedia (creation/redemption mechanics, creation unit size of 50,000 shares, AUM breakdown, market-share table)
- SPDR S&P 500 ETF Trust — Wikipedia (SPY launch date, AUM over $600 billion as of February 2025, 0.0945% expense ratio, unit investment trust structure)
- SEC Final Rule — Exchange-Traded Funds (2019) (Rule 6c-11 background on standardized ETF regulation and custom baskets)
- Investment Company Institute — ETF FAQs (industry-standard descriptions of authorized participants and in-kind flow)
Disclosure: This article is for informational purposes only and is not investment advice.