Exchange Traded Funds: A White Paper       Page 6
Some of these institutional investors hold the creation units in their own portfolios. Others, generally broker-dealers, break-up the creation units and offer the ETF shares on the exchanges where individual investors can purchase them from brokerage firms just as they would any other listed security.

ETFs are redeemed the same way but in reverse. Broker-dealers buy enough ETF shares from individual investors to make a creation unit block. The broker-dealers then exchange with the ETF sponsor the creation unit for a basket of securities and the small amount of cash. Other institutional investors will trade back the creation units in their portfolio with the ETF sponsor for securities and cash.

Creation units are continually created and redeemed due to investor demand and for arbitrage purposes. The values of the ETF track closely but do not match exactly the values of the underlying security so institutional investors can measure the price of the underlying securities in the index against the price of the ETF. If the price of the underlying securities is higher than the price of the ETF, the institutional investors will trade a lower-priced creation unit back to the ETF sponsor in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the institutional investor will trade back to the ETF the lower-priced securities in exchange for a creation unit. This arbitrage mechanism eliminates the problem associated with closed-end mutual funds - the ETF trading as a premium or discount to the value of the underlying portfolio.

All of these creations and redemptions are very important, not only to keep the price of the ETF properly reflecting the value of the underlying securities, but also for the tax reasons discussed later.

The individual investor can purchase ETF shares through the exchange and the shares might come from either individual investors or from the institutions. It is important to remember that ETFs are not mutual funds and that there is a lot of behind-the-scenes swapping of securities.
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