What Are Creation Units? Key Concepts and Common Practices in ETFs

What Is a Creation Unit?

A creation unit is a fundamental building block in the world of exchange-traded funds (ETFs). It refers to a large block of new shares that an ETF company sells to broker-dealers for distribution in the open market. These units typically consist of between 25,000 and 600,000 ETF shares, and they play a crucial role in how ETFs are issued and traded on financial exchanges.

Understanding creation units is key for investors and financial professionals looking to navigate the nuances of ETF trading. We'll explain how creation units work, their risks and rewards, and the crucial role of authorized participants in ensuring that ETF prices accurately reflect their underlying assets.

How Creation Units Work

An ETF creation unit is central to the process an exchange-traded fund issuer undergoes when creating a brand-new exchange traded fund or issueing new shares of an existing fund to the market. ETF issuers work with ETF distributors to issue new shares in creation units to broker-dealers.

Creation units are typically sold to broker-dealers, who can choose to pay for the shares in various forms. When sold, shares are valued at the fund’s net asset value (NAV). However, exchange-traded fund issuers can negotiate with broker-dealers on the terms of the sale, typically receiving cash or in-kind shares for the transaction. In-kind shares are a common way to pay for the shares in a creation unit. In-kind share transactions require the buyer to assemble a portfolio of securities, which are then transferred to the issuing company as a kind of trade. Because of this exchange, the creation of unit sales can generate profits and losses for the broker-dealer prior to the exchange listing. These profits and losses can have tax implications. Thus, broker-dealers have considerable risks when buying new creation units.

The Role of Authorized Participants in ETFs

Exchange-traded fund issuers use creation units for new share issuance through broker-dealers. They also have relationships with broker-dealer trading desks, which act as authorized participants. Authorized participants are unique to open-end ETFs and serve to monitor significant deviation from a fund’s NAV in the trading market. Since ETFs trade actively throughout the day on financial market exchanges, they offer premiums and discounts to their accounting NAV. Authorized participants follow this market mechanism and help manage premiums and discounts to NAV trading.

Common Industry Practices for Creation Units

The State Street Global Advisors SPDR Series is one of the largest in the market for ETF sector investing and offers a good example of how creation units are utilized. For starters, all funds in the Series have the same creation unit provisions. At various times, the Series issues creation units of each sector fund at the fund company’s discretion to market makers or other broker-dealers. For the SPDR series, creation units are issued in blocks of 50,000 shares. Financial institutions provide in-kind securities and/or cash for the market value of the creation unit. Creation unit transactions are facilitated by ALPS Portfolio Solutions Distributor, Inc.