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Exchange-traded funds (ETFs) are one of the most successful financial market innovations in recent years. Since 1993, when State Street introduced the first U.S. ETF, the number of funds has increased to 1,159 with approximate total assets of $1.3 trillion under management.1 ETFs owe their success largely to some combination of their generally low fees and the close tracking of their realized investment returns with those of the target benchmark index. The ETF product space has grown to include many targeted exposures previously unavailable to most investors in any form, much less through vehicles available for intraday trading.
To facilitate close tracking of ETF shares with the value of fund assets, the product design features two layers of liquidity. ETF shares are listed and traded on exchanges, providing intraday liquidity. ETFs offer an additional layer of liquidity through the primary market, allowing for the creation of new fund shares and the redemption of existing fund shares.
In contrast, other investment companies typically offer only one layer of liquidity. For example, open-end mutual funds offer once-daily liquidity at the fund's net asset value (NAV). Traditional closed-end funds trade in the secondary market at prices that often differ meaningfully from the funds' NAV (Pontiff [1996]). Numerous empirical studies find that ETF returns closely track those of the benchmark index, implying that the dual layers of liquidity, combined with proper fund management, succeed at creating intraday tradeable vehicles that replicate the benchmark index's returns (Elton, Gruber, Comer, and Li [2002]; Buetow and Henderson [2012]).
Critical to ETF return tracking and liquidity is the primary market, where authorized participants (APs) create and redeem shares, alleviating imbalances between the supply of and demand for ETF shares in the secondary market. Typically, APs are quantitative trading firms. For the majority of ETFs, primary market creations and redemptions take place through in-kind exchanges. ETFs publish a daily list of underlying securities and their respective quantities, which constitute the basket of securities that equals one creation unit.2 In response to excess demand for ETF shares in the secondary market, APs act to create additional ETF shares by purchasing the basket of underlying securities. APs may hedge their position in the basket by short-selling ETF shares. Although the actual...