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ETF 102: Why ETFs Layer Up On Liquidity

February 18, 2020

Watch Time 2:31 MIN

ETFs can offer investors a versatile set of tools when it comes to achieving their investment goals. Understanding the basics and key attribute of ETFs is an important first step to including them in your investment portfolio.

ETFs are open-ended investment funds, the number of shares available can fluctuate based on supply and demand through the creations and redemptions process.

But how does it work?

Think of individual stocks as pieces of chocolate. Now let’s say you would like to purchase an assorted box of chocolates—or ETF.

There are 2 markets for ETF shares: the secondary and primary markets.

The secondary market includes well-known securities exchanges where investors buy and sell existing shares of ETFs -- think of this as the counter front at a candy shop, otherwise known as a brokerage firm.

The primary market is where ETF share creations and redemptions occur -- or the facility where the chocolate is boxed.

If an investor wants to buy a box of chocolates, they go to the candy shop and if a box of chocolates is available, they can purchase it right away.

But what if the person wants to buy 20 boxes of chocolate and the shop doesn’t have the supply? This is where creation comes into play.

The cashier goes to the manager -- or authorized participant -- who is in charge of managing the supply of individual chocolates and boxes of chocolates and lets them know about the large order.

The cashier gathers all the chocolates according to the recipe and hands them off to the AP.

From here, the AP takes all the individual chocolates to be boxed.

Once finished, they give the boxes to the AP, or manager, who then brings them back to the cashier to sell in the store front..

Now, what would happen if the investor had 20 boxes of chocolate and wanted to return them? ETF redemption.

The investor brings the boxes to the candy shop where the cashier takes them back.

The shop already has more than enough boxed chocolate, so the manager takes them to the back, breaking them down into single pieces of chocolates.

With creation and redemption, the supply of boxed chocolate stays in line with demand and the well-known liquidity and tax efficiency advantages of ETFs are possible.

Remember, ETFs are like a box of chocolates -- except you know what you’re going to get.

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