Authorized participants: The hidden mechanics behind ETF pricing

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The invisible engine of the ETF market.

Encyclopædia Britannica, Inc.

Exchange-traded funds(ETFs) are popular because they’re inexpensive, tax efficient, transparent, and easy to trade throughout the day. Behind those investor-friendly features is a little-known creation-and-redemption system that relies on large financial firms known as authorized participants, or APs.

Once you understand what these firms do, it’s easier to see why ETFs are priced the way they are and why they’re generally more tax efficient than mutual funds.

An authorized participant isn’t just another Wall Street firm. Only APs can create and redeem ETF shares directly with the fund issuer. They help maintain liquidity; keep market prices aligned with the value of an ETF’s underlying holdings, or net asset value (NAV); and improve tax efficiency.

APs help manage the supply of ETF shares in the secondary market. These firms are U.S.–registered, self-clearing broker-dealers, meaning they handle the settlement of their own securities trades rather than relying on another firm. They sign agreements with ETF distributors that allow them to create and redeem shares for specific ETFs. Usually these firms are large financial institutions with the capital, technology, and regulatory approval to trade in the primary market.

To create shares of an ETF, such as one that tracks the S&P 500, an AP assembles a creation basket—a group of securities that mirrors the ETF’s underlying holdings. In exchange, the ETF issuer delivers a creation unit, typically 50,000 ETF shares.

The process involves three basic steps:

To redeem shares, the process is reversed:

Authorized participants don’t create or redeem ETF shares merely to adjust supply. They also profit through arbitrage—that is, buying and selling the same or related assets to take advantage of small price differences—when an ETF’s market price drifts above or below its NAV.

If an ETF trades at a premium, an AP can create new shares and sell them into the market, increasing supply and pushing the ETF’s market price back toward its NAV. If an ETF trades at a discount, an AP can buy ETF shares, redeem them with the issuer for the underlying securities, and sell those securities, reducing the supply of ETF shares and helping push the ETF’s market price back toward its NAV.

Because APs execute these transactions, they—not the ETF itself—bear the costs of buying and selling the underlying securities. Those costs are reflected in the ETF’s bid-ask spread—the small difference between the price buyers are willing to pay and sellers are willing to accept—rather than being borne directly by the fund.

ETFs are popular in large part because they are tax efficient, making them the investment vehicle of choice for taxable accounts. The creation-and-redemption process is a key reason why.

When APs redeem ETF shares, the ETF issuer typically returns a basket of the fund’s underlying securities instead of cash. This in-kind exchange generally doesn’t trigger capital gains because the securities change hands without being sold.

The ETF issuer can choose which securities to transfer to APs during an in-kind redemption. By transferring securities with the largest unrealized gains, the fund can remove them from its portfolio without realizing taxable capital gains, helping reduce future capital gains distributions to shareholders.

The tax advantage is reflected in the numbers. Morningstar data from 2024 shows that just 7% of U.S. equity ETFs had capital gains distributions, while 78% of mutual funds did. Another quirk of the mutual fund redemption process shows up when markets have a losing year and investors are still socked with capital gains distributions. In 2022, when the S&P 500 fell by more than 18%, two-thirds of all U.S. equity mutual funds still distributed capital gains, averaging 7% of NAV, according to Morningstar.

For investors in taxable accounts, that means ETFs are generally less likely than mutual funds to generate unexpected capital gains distributions.

ETFs are generally more tax efficient than mutual funds, but that advantage isn’t the same for every type of ETF. Bond ETFs, for example, can sometimes distribute more capital gains than equity ETFs because some bonds can’t be transferred through the in-kind redemption process. Certain derivatives, commodities, emerging-market securities, and other investments are also subject to tax or market rules that limit in-kind transfers.

The creation-and-redemption process usually keeps an ETF’s market price close to the value of its underlying holdings, but it isn’t foolproof. During periods of severe market volatility, APs may have a harder time arbitraging away premiums and discounts.

That happened during the COVID-19 market sell-off in March 2020, when some bond ETFs traded at unusually wide premiums and discounts to their NAVs even as APs worked to stabilize prices. As markets recovered, those gaps narrowed, demonstrating both the resilience of the ETF structure and the limits of what APs can do.

Authorized participants work behind the scenes to keep ETF prices close to their net asset value, a critical function for market efficiency and investor protection. Their creation-and-redemption activity also helps keep ETFs liquid and generally more tax efficient than mutual funds. Most investors never interact directly with an AP, but every ETF investor benefits from the role APs play behind the scenes.