How Is an ETF Created?

Only authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from or to the fund provider, and then only in creation units. Creation units are large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities that match the strategy of the fund.

Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.

Other investors, such as individuals using a retail brokerage, trade ETF shares on the secondary market.

The market prices of the shares will fluctuate in response to changes in the value of the underlying index and supply and demand for the ETF shares. Both of these variables can cause the ETF's market prices to trade at, above, or below the fair market value of the underlying securities in the benchmark index. The price above or below market value is known as the ETF's premium or discount.

The following is a step-by-step view of the creation process.