How To Start An ETF
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Starting an ETF can be a tough problem to starters. At first blush, exchange-traded funds are a piece of cake because they can be traded like stocks and they give many of the same benefits of traditional open-end mutual funds. Some would think that their creation is no different from stocks. This is seemingly a correct assumption. But in a deeper dissection, you will find out that they work very differently compared to other funds or stocks.
In mutual funds, you can invest by purchasing securities with cash on the open market. ETF is different because ETF shares are made and redeemed through a unique in-kind transaction—the creation/redemption process. The whole transaction would call for a relatively lower cost as compared to other funds.
The whole process begins with an authorized participant and his investment idea. They are sometimes called dealers/brokers who basically make the market for an ETF. The need to fill an order or to produce inventory is usually the basis of the creation of the ETFs which is initiated by the authorized participant. The authorized participant may also initiate the whole process when there is a chance for a certain investor to simultaneously buy and sell the same security. This is technically known as the arbitrage.
How do things really go on when you get to start an ETF?
It starts with the stocks being delivered to the authorized participant through the Custodian Bank. The investors need not to worry about the transaction or trading expenses. All the trading and transactions costs are shouldered by the authorized participant. This transaction forms the tax basis or the cost basis for the new accumulating securities included in the entire portfolio. This is considered as an in-kind transaction because common stock is traded for fund shares and because no cash is involved. This would be a great help in curbing tax liabilities.
When the authorized participant acquires the ETF shares, it obtains the liberty to sell them in the open market. And from there on, the Exchange-traded Funds’ shares go on a cycle as they are sold and resold among the investors.
The reverse of the creation process is the redemption process. This is where the authorized participant buys a large number of ETF shares for the underlying set of securities and have these sold to the market. Still, the authorized participant will cover all the transaction cost and the trading costs for the portfolio. The investors are worry-free insofar as the costs are concerned.
The whole process seems to be too technical to comprehend but in a nutshell, the ETF starts with the authorized participant who creates and redeems the shares of an ETF. When making an exchange-traded fund, common stock is traded for ETF shares. This is known as an in-kind transaction because no cash is traded for ETF shares. Lastly, Exchange-traded funds’ shares are traded in-kind for equal value, so there will be no taxable gains over the transaction. ETF really promises tax efficiency.
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