When discussing ETFs, it's important to understand the roles of the key participants involved in their trading creation and management. While most ETF trading occurs in the secondary markets where investors buy and sell ETF shares directly with other market participants. In other words, they access liquidity directly. There is also a process known as in kind creation and in kind redemption, which plays a crucial role in market stability and aligns share supply with demand. The in-kind creation and in-kind redemption processes occur when there is a need to manage the supply of ETF shares to align with investor demand. These mechanisms help maintain price stability and keep ETF share prices closely aligned with their net asset value or NAV. The NAV represents the total value of an ETF's assets like stocks or bonds, minus its liabilities, divided by the number of outstanding shares. It's essentially the per share value of the fund. In practice, there are three main players involved in ETF trading brokers, authorized participants, and ETF managers.

Let's look at the role of the broker first. Investors typically place their orders to buy or sell ETF shares through brokers paying standard commission rates. These transactions occur on the exchange and are independent of the creation process as long as the secondary market has sufficient liquidity. When liquidity in the secondary market becomes insufficient, brokers may rely on authorized participants or APs to facilitate the creation or redemption of shares to meet investor needs. Authorized participants are large institutions, often banks or trading firms that have a special agreement with the ETF manager. When there's insufficient supply of ETF shares in the market, authorized participants or APs can initiate the creation process by delivering a basket of securities that matches the ETF's underlying portfolio to the ETF manager. In exchange, they receive newly created ETF shares, which they can sell to meet investor demand. Conversely, in periods of excess supply, APs can redeem ETF shares by returning them to the fund in exchange for the underlying securities.

One of the key advantages of the in-kind process is its ability to ensure that the value of ETF shares remains closely aligned with the nav. Suppose an ETF's share price in the secondary market starts trading significantly above its NAV due to strong demand.

In this case, APs can step in and create new ETF shares by delivering the matching basket of underlying securities to the ETF manager. These newly created shares increase supply, helping to bring the ETF's price back in line with its NAV.

Conversely, if the ETF's share price falls below its NAV due to weak demand, APs can redeem ETF shares by delivering them to the fund in exchange for the underlying securities. This redemption reduces supply helping to restore alignment between the ETF price and its NAV.

Without this mechanism, large price discrepancies could persist, undermining the efficiency and attractiveness of ETFs as investment vehicles.

The third party involved in ETF trading is the ETF manager. The ETF manager oversees the operation of the fund, ensuring that it tracks its benchmark index as closely as possible. The ETF manager also handles the operational aspects, including collecting and distributing dividends. Managers generate revenue through the fund's ongoing charges, figure or OCF.

The ongoing charge figure is a transparent measure of the fund's total management costs, including administrative and operational expenses. Taking a real world example, consider the SPDR S&P 500 ETF or SPY, managed by State Street. This ETF seeks to replicate the performance of the S&P 500 index by holding a portfolio of common stocks with weights, mirroring the index.

Dividends on the underlying stocks are collected and distributed quarterly to ETF holders net of fees and expenses. Investors should note that the dividend yield on the ETF is generally lower than on the index due to these associated costs.