How do exchange-traded funds (ETFs) work?

While the distinction between active and passive management sets the high-level strategy, the true "magic" of an exchange-traded fund (ETF) lies in its daily operations. Unlike mutual funds, which require managers to buy and sell securities manually to meet investor demand, ETFs utilize a streamlined "Creation and Redemption" mechanism. This process is implemented by Authorized Participants (APs)—typically large institutional entities—who exchange baskets of underlying securities for blocks of ETF shares, known as creation units. By relying on these in-kind exchanges rather than cash transactions, ETF managers can scale the fund's size without the administrative friction or trading costs associated with traditional open-end funds.

This structural design offers a significant advantage: superior tax efficiency. (See figure below. Source: State Street Global Advisors.) Because the manager is exchanging securities in-kind with an AP rather than selling them on the open market, the fund avoids triggering capital gains taxes at the fund level. This allows the ETF to shed low-cost-basis shares through the redemption process, effectively raising the portfolio's average cost basis and shielding investors from the "tax drag" common in mutual fund portfolios. For the end investor, this means taxes are generally only realized upon the personal sale of their own shares, not as a result of the manager’s internal rebalancing.

Furthermore, the ETF structure creates a self-regulating pricing loop through arbitrage. Because ETF shares trade on secondary exchanges like stocks, their price can occasionally drift away from the fund’s Net Asset Value (NAV). When a premium or discount appears, APs are incentivized to step in: they buy the cheaper asset and sell the more expensive one until the price equilibrium is restored. This constant monitoring ensures that an ETF’s market price remains tightly tethered to the value of its underlying holdings, providing investors with reliable liquidity even during periods of heightened market volatility.