I found this neat video “The ‘Aha’ Moment – Understanding ETF Liquidity” on the iShares blog. This colorful little cartoon attempts to explain the creation/redemption process of ETFs with the analogy of flower bouquets.
The flowers are the shares of the individual stocks and the bouquets are the ETF shares. Overall, it’s not bad, but when it actually gets to the creation/redemption process the “Aha” moment left me a little confused, with a little bit too much on the flowers and not enough translation on what this means to stock shares.
Basically, an ETF share (bouquets) is like a share of the index it follows. It represents the value of all the underlying stocks (flowers) in the index. However, when the demand rises for ETF shares, they need to create more ETF shares. It sorta glides over the most important part. If the investor wants 500 shares of an ETF (500 bouquets) with 100 stocks (flowers) in the index, then the authorized participant needs to go the market himself to get, in this case, 50,000 flowers, 500 of each of the 100 individual stock (flowers) in the index. He can get them either from the market maker, the AP’s inventory, or others in the market. The AP takes this basket of securities (flowers) and trades them with the ETF (bouquet) maker, who in turn gives him 500 shares of the fund (bouquets), each holding 100 stocks (flowers). Because the 50,000 flowers are equal 500 bouquets it’s an even trade.
Was the video perfectly clear to you?