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What are the technical differences between ETFs and mutual funds?

From a technical standpoint, an ETF works a bit differently than a mutual fund does, even a passively managed mutual fund that tracks the same index as the ETF. Mutual funds essentially buy and sell securities for cash on the open market; the process for an ETF is more complex.

An ETF is created when a large institutional investor, often a bank, broker-dealer, or other financial services firm, assembles large holdings of securities into a portfolio that approximates a specific market index–for example, the Nasdaq 100. The financial institution, known as an authorized participant (AP), exchanges those securities with the ETF’s manager, receiving in return large blocks of ETF shares. Those blocks, each of which may include anywhere from 10,000-100,000 ETF shares, are known as creation units. The authorized participant may hold those creation units in its portfolio(s), but it may also break them up and sell ETF shares in smaller quantities to other investors–for example, individual investors who buy and sell them on the open market as they might any other security.

The original basket of securities is held at a custodial bank and monitored by the ETF’s manager. When an authorized participant wants or needs the individual securities rather than ETF creation units, it simply assembles enough ETF shares to make up a creation unit. It returns the creation unit to the ETF in exchange for the equivalent securities (based on the creation unit’s net asset value), plus any cash accumulated from dividends. Those individual securities can then once again be sold on the open market, or if borrowed, returned to individual owners who loaned them to the authorized participant.

Creation units are constantly created and redeemed by an ETF, depending on supply and demand. The authorized participant’s decision about whether to hold creation units or the shares they represent may be determined by their relative values. The AP may be able to profit by using arbitrage to take advantage of any difference between the value of the creation unit and the aggregated value of the underlying securities. However, competition typically tends to keep ETF prices relatively close to the NAV of the underlying securities.

The exchange of creation units for the securities that make up the ETF’s index involves no cash and is considered an in-kind trade. As a result, it doesn’t trigger any capital gains for the fund itself and in turn, individual investors in shares of the ETF. By contrast, when a mutual fund sells shares of the securities it holds–for example, to meet shareholder redemptions–it may incur capital gains. By law, those gains must be distributed each year to the mutual fund’s shareholders, for whom that distribution is considered a taxable event.

The in-kind exchange of creation units for the underlying securities minimizes or eliminates internal capital gains for an ETF, which in turn results in tax efficiencies for the individual investor in it.