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Exchange-Traded Funds (ETFs): Creation, Operation, and Organization under the Investment Company Act of 1940

An exchange-traded fund (“ETF”) provides securities that offer institutional investment strategies, such as those offered by a mutual fund, but makes them available on security exchanges, just like stocks.1 Consequently, this unique and dynamic investment vehicle has grown rapidly since the first ETF began operation in 1993.2 $1.4 trillion of net new ETF shares have been issued in the last 10 years—expanding the U.S. ETF industry to nearly $2.0 trillion in assets at year-end 2014.3 This blog is the first in a two part series, examining the creation and operation of ETFs in the context of the Investment Company Act of 1940 (“1940 Act”). This first blog discusses how an ETF is created and operated, which is necessary to understand the implications of the 1940 Act. The second blog examines the creation of the first ETF under the 1940 Act and analyzes its evolution up until today.

An ETF originates when a sponsor, usually a large company or financial institution, selects an investment objective—e.g., replicating the returns of the S&P 500 index—and invests in assets to achieve their investment objective.4 Next, the sponsor develops a creation/redemption basket which lists the names and quantities of cash, securities, and other assets that represent the ETF’s investment portfolio.5 From here, the operation of the ETF is based on two markets: primary and secondary.6

In the primary market, an authorized participant—typically a large institutional investor such as a broker-dealer—submits an order for a creation unit.7 The authorized participant provides the creation basket to the ETF sponsor and in return receives a creation unit—a specified number of ETF shares generally ranging from 25,000 to 250,000.8 Once the authorized participant receives the creation unit, they’re free to transact using those shares on the secondary market—e.g., selling the shares to clients or investors, selling the shares over exchanges such as NASDAQ or Amex, or holding them for profit.9

The creation basket and creation unit system help to ensure that the ETF’s shares trade at a price that approximates its underlying value.10 For example, suppose the ETF’s share price is trading very low in the market (on the securities exchange) compared to the underlying assets that the sponsor is invested in. The authorized participant would then be incentivized to purchase the amount of ETF shares required for a creation unit (let’s say 50,000 shares) and exchange them for a creation basket from the sponsor, quickly selling the assets of the creation basket for a profit.11 Put another way, the authorized participant can purchase the cheap ETF shares, exchange them for the underlying assets, and sell off the expensive underlying assets in the market. This stream of transactions—buying ETF shares and selling the underlying assets—corrects the market; increasing the price of ETF shares and decreasing the price of the underlying assets until this arbitrage strategy was no longer profitable.12 At that point, the ETF shares would trade at a price that reflected the underlying investment assets of the sponsor.13

These features of how ETFs are created and operated are important to understand and appreciate the implications of the 1940 Act, to be discussed in blog two of the series.


  1. See William A. Birdthistle, The Fortunes and Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds, 33 Del. J. Corp. L. 69, 69 (2008). 

  2. Id. at 71-72. 

  3. Inv. Co. Inst., 2015 Investment Company Fact Book: A Review of Trends and Activities in the U.S. Investment Company Industry 23 (55th ed. 2015). 

  4. Inv. Co. Inst., supra note 3, at 23. 

  5. Id. at 62. 

  6. Id. at 62-64. 

  7. Id. at 62. 

  8. Id. 

  9. Id. 62-63. 

  10. See Birdthistle, supra note 1, at 80-81. 

  11. Id. 

  12. Inv. Co. Inst., supra note 3, at 65. 

  13. See Id.