The Creation Unit: How ETF Units Are Made and Unmade
A creation unit is the fixed block of units in which an exchange traded scheme deals directly with a large participant. New units come into existence when a block is delivered in, and units are cancelled when a block comes back. Ordinary buying and selling on an exchange moves existing units between holders and changes nothing about how many exist.
An exchange traded scheme is odd in a way that is easy to miss. In an ordinary open ended scheme, the plumbing is obvious: money comes in and units are created, money goes out and units are cancelled, and the number of units in issue rises and falls with the money. On an exchange, nothing like that happens. A purchase of units of an exchange traded scheme is almost always a purchase from another holder who is selling. The scheme is not on either side of that transaction. The scheme receives nothing, pays nothing, and issues nothing. A vehicle whose units only ever changed hands would be frozen at whatever size it started at, and the creation mechanism exists to answer that problem and no other.
So there has to be a second door. Not the exchange, where holders meet holders, but a direct door into the scheme itself. The door has a width, a list of who may pass through it, a requirement about what they carry, and an effect on the price on the exchange simply by being there. The direct door is the least glamorous part of an exchange traded scheme and the part that makes the rest of it work.
The teaching record behind this material runs on Girnar Asset Management Limited, an invented Indian asset manager, and two of its schemes: the Girnar Large Cap Equity Fund, an open ended equity scheme run by Kalyani Bhagat, and the Girnar Broad Market Index Fund, a tracker following an unnamed broad index. Sohail Merchant heads operations at Girnar Asset Management. Neither scheme is exchange traded. There is no exchange traded scheme in this record at all. The mechanism therefore comes with no figure attached to it, and that absence is a limit of the record rather than a limit of the mechanism.
A few things are settled elsewhere and are used here rather than rebuilt: a scheme, the people who run it and the holders a trustee company protects; a unit and the way a value per unit is struck; an expense ratio and the fact that it runs against the scheme's assets daily. Where index schemes, exchange traded schemes and schemes of schemes sit on the shelf. And, from earlier in this sequence, that a tracker delivers its index less its charge and less a residualWhat is left of a difference after the part that can be named has been taken out of it., and that a holder of an exchange traded scheme usually deals with another holder rather than with the scheme.
Ten thousand people buy units of an exchange traded scheme on an exchange today. How much money reached the scheme itself?
Why does an exchange traded scheme need a mechanism of its own?
Because ordinary trading is sideways motion and nothing else. Think of a housing society where flats are bought and sold. Every sale changes who lives where, and not one of them changes how many flats the building has. The builder is the only party who can add a floor, and the builder is not involved when two residents swap. An exchange works the same way. A transaction between two holders moves units from the seller's account to the buyer's account, and the total number of units in existence at the end of the day is exactly what it was at the start.
A fixed count is fine for a share. A company issues shares once and then mostly leaves the count alone. A fixed count is a serious problem for a pooled scheme. A pooled scheme is supposed to grow when people want more of it and shrink when they want less. If a hundred thousand new buyers arrive and the number of units cannot change, the price they pay each other is the only figure left that can move. The price would drift away from what the underlying holdings are actually worth, and keep drifting. The creation mechanism exists so that the supply of units can respond, and no other arrangement changes how many units exist.
What exactly is a creation unit?
A creation unitThe fixed block of units in which a scheme will deal directly, rather than one unit at a time. is the block size in which the scheme is willing to use that second door. Not a single unit, and not an amount of the participant's own choosing. One fixed block, stated in the scheme's own terms, and dealings through the direct door happen in whole blocks of that size or not at all. A request for half a block is refused. A request for one and a half gets one block, and the remaining half is somebody else's problem on the exchange.
Why so rigid? Because going through that door is not a payment, it is a transfer of an entire slice of the portfolio. The scheme is not receiving a cheque and adding it to a pile. The scheme is handing over, or taking in, a proportional slice of everything it holds: every line in the portfolio, in the right relative amounts. Assembling a slice is an operational job with a fixed cost attached to it, and the fixed cost does not get smaller when the amount does. Doing that job for a small sum would cost more than the job achieved. The block is deliberately large because the work of assembling or breaking up a slice of a portfolio barely shrinks with the size of the transaction, so a small block would be all cost and no purpose.
Consider a wholesaler in a cloth market. The wholesaler will sell a full bale at the wholesale price and will not cut two metres off it, not because two metres is unimportant but because opening, measuring, cutting and rewrapping a bale costs the same whether the buyer takes two metres or twenty. So the wholesaler deals in bales and lets the retail shop deal in metres. The exchange is the retail shop. The direct door deals in bales.
How many units are in that block, and whether any minimum applies to a direct dealing with the scheme, is set by the scheme's own terms and constrained by rules the Securities and Exchange Board of India (SEBI) makes. The figures differ between schemes, and they are revised. A block size copied out of them would not become dated so much as become wrong. The current position is read at sebi.gov.in on the day it matters.
Why is a creation unit a large block rather than a single unit?
Who deals in one, and who never does?
Large participants who have made an arrangement with the scheme to do so, acting for themselves. Every condition on who may deal directly with a scheme, on what terms and in what size, is set by SEBI. A participantA large party that has arranged with a scheme to deal with it directly in blocks, rather than through an exchange. of that kind acts by role rather than by name, and the role is what the mechanism depends on.
Who does not deal in one matters far more. An ordinary holder never touches this mechanism, cannot use it, and every transaction they make in an exchange traded scheme is with another holder across an exchange. A holder of an exchange traded scheme who wants out sells on the exchange to somebody who wants in, rather than sending a redemptionHanding units back to the scheme so they are cancelled, rather than selling them to another holder. request to the scheme and waiting for a value to be struck. An ordinary open ended scheme would require exactly that. The two routes look similar from a distance and are not the same road at all.
The arrangement inverts something people assume. In an ordinary scheme the small holder deals directly with the scheme and nobody deals on an exchange. In an exchange traded scheme the small holder deals only on an exchange and never with the scheme. The direct door is the wholesale door, and the retail customer stands in the retail shop. Neither arrangement is better. They are different plumbing for different vehicles.
An ordinary holder wants to redeem their exchange traded units with the scheme itself. Can they?
What is actually delivered when a block is created?
A participant delivers the underlying holdings to the scheme instead of money. What did the scheme avoid having to do?
In kind delivery is where the mechanism earns its keep. A block can be delivered to the scheme as the basketThe list of securities, in stated proportions, that stands behind one block of units. of underlying securities rather than as money. The participant turns up not with cash but with the actual holdings, in the proportions the scheme wants them, and receives a block of newly issued units in exchange. Delivering the securities themselves rather than money is what in kindSettled by delivering the actual securities rather than by paying money. means, and it is not a technicality.
When a block arrives as holdings rather than as money, the scheme receives the portfolio it wanted without having to go into the market and buy it, so the work of turning money into a portfolio, and the cost of doing that work, sits with the participant instead of with the scheme. An ordinary open ended scheme taking in money has to spend it: somebody has to place the orders, deal at whatever prices are available that day, and live with the difference between the price they hoped for and the price they got. In kind creation does not make that job disappear. The job moves to the participant.
The household version is a wedding. The caterer can be handed money and left to buy the vegetables, or the household can arrive with the vegetables already bought. The vegetables were bought either way, by somebody, at some price, with somebody bearing the trouble of the market that morning. The arrangement changed whose morning it was. Nothing about the second arrangement makes vegetables cheaper in the abstract, and a claim that it did would be a claim about size rather than about who carried the basket.
The cash route exists as well. A scheme may deal in money instead, or in some combination, and which applies is a matter for the scheme's own terms and for the rules SEBI sets, read at sebi.gov.in. Where units are held in dematerialised form, the mechanics of that holding are described by the National Securities Depository Limited (NSDL) at nsdl.co.in and Central Depository Services Limited (CDSL) at cdslindia.com.
How does the redemption side run?
Backwards, and that is the whole of it. A block of units comes back to the scheme, the scheme hands over the corresponding slice of holdings or its value, and the units are cancelled. Cancelled, not transferred: they stop existing, they are not parked with the manager and they are not held for somebody else. Redemption in this setting is the exact mirror of creation, with the arrows reversed and nothing else changed.
The consequence is the quiet advantage of the arrangement, and it is easy to overclaim. In an ordinary open ended scheme, a large exit has to be funded. Somebody wants money out, the scheme does not keep everything in cash, so the scheme sells holdings to raise it, and the dealing that follows happens inside the pool. Everybody still in the scheme is in the pool while that happens. When a block is redeemed in kind the exiting party is handed the holdings themselves, so the continuing holders are not being asked to fund somebody else's exit by selling anything.
Picture ten households who jointly bought a shop's worth of stock. One of them wants out. Either the nine sell goods at whatever the market gives them that week and hand over money, or they count out that household's tenth of the shelves and let them take it away. In the second arrangement the nine are left with exactly the same mix they had before, in smaller quantity, and nobody had to accept this week's prices to make the exit happen.
A block is redeemed in kind. What did the continuing holders avoid?
What does this do to the price on the exchange?
The mechanism gives somebody a reason to close a gap. On an exchange, the traded priceThe price at which units change hands on an exchange between one holder and another. is whatever a buyer and a seller agree to, and there is nothing in the act of agreeing that ties it to the value of the basket sitting inside the scheme. Left alone, the two could wander apart. The two do not wander far, and the reason is the direct door.
Work the two directions. Suppose the traded price sits above the value of the basket. A participant can assemble the basket, deliver it to the scheme, receive a block of units at the value of the basket, and sell those units on the exchange at the higher price. Doing that adds units to the market and pushes on the price from the supply side. The participant keeps the difference for the trouble. Now suppose the traded price sits below. A participant can buy units on the exchange cheaply, hand a block back to the scheme, and receive the holdings at the value of the basket. Doing that takes units out of the market and pushes the other way.
The gap narrows because narrowing it is profitable, and that is the whole of the connection between the mechanism and the price. Nobody is enforcing anything. Nobody is obliged to act. The mechanism simply arranges the world so that a gap of any size is an opportunity somebody is watching for, and opportunities that are being watched for tend not to last.
The traded price of an exchange traded scheme sits below the value of the basket behind it. Who has a reason to act?
And what does the mechanism not do?
Nothing described above forces the traded price to equal the value of the basket. Not approximately, not at the close, not ever. The mechanism supplies a reason for somebody to act when the gap is wide enough to be worth acting on, and the words wide enough are carrying the whole sentence.
Acting on a gap is not free. Somebody has to assemble or break up a basket, deal in every line of it, move the units, and carry whatever happens to prices while all that is going on. The effort has a size. A gap smaller than that size is not an opportunity at all; it is a loss dressed as one, and nobody takes it. So the gap closes to the point where acting on it stops being worthwhile and then it stops closing. Taking creation and redemption as a promise that price equals value turns an incentive into a rule, and no error about this mechanism is made more often.
Where exactly that stopping point sits moves from scheme to scheme, from day to day and from one moment of the day to another. A gap of that kind is looked up on the day, in whichever direction it happens to lie, and never carried across from one scheme to the next.
So does the mechanism ensure that the traded price equals the value of the basket?
The error that gets made, and what it costs
A reader follows every step above correctly. Participants can create at the value of the basket. Participants can redeem at the value of the basket. Therefore, the reader concludes, an exchange traded scheme trades at the value of the basket. Every step of that reasoning is sound except the word therefore.
Who makes the failure is the interesting part. Not the reader who understood nothing, but the reader who understood the mechanism properly and then took it one step further than it goes. An incentive was read as a promise. The mechanism gives somebody a reason to close a gap; reasons run out when the gap gets small enough that closing it is not worth the effort, and the account above sets out the shape of exactly that.
The cost lands on a holder rather than on the reader. Someone who believes the price they receive is the value of what they hold never asks what the difference was on the day they bought or the day they sold, in either direction. The loss is not spectacular and it does not announce itself. The cost is simply a question that never got asked at the only moment it could have been answered.
The fix is a change of category rather than a change of vigilance: creation and redemption keep a gap small and do not remove it, and where the size of that gap matters to a decision, look it up rather than assume a zero.
Which quantities are absent here, and why does that matter?
A worked example would need a block size, a traded price and a gap between that price and the value of a basket before it could say anything at all, and this record holds none of the three. A block size, a participant, a traded price and a gap against value are absent from the record rather than omitted for brevity, and an absent quantity cannot be borrowed from a neighbouring scheme.
The Girnar Broad Market Index Fund is an index fund and is not exchange traded, so no creation unit applies to it, no block size may be attached to it, and no traded price, premium or discount may be quoted for it or for anything else here.
What arithmetic does survive the refusal?
One calculation, and it belongs to the tracker rather than to any exchange traded scheme. For the stated year, the Girnar Broad Market Index Fund returned 12.12 per cent net, measured value per unit to value per unit, against 12.40 per cent for the unnamed broad index it follows. Subtract: the shortfall is 0.28 percentage points. Now split it. The Girnar Broad Market Index Fund charges 0.20 per cent of its own assets a year, so a scheme that tracked the index perfectly and charged that would have returned 12.20 per cent. The Girnar Broad Market Index Fund returned 12.12 per cent. The difference between the perfect tracker and the actual one is 0.08 percentage points. Add 0.20 to 0.08 and the result is 0.28, so the arithmetic closes in both directions.
Take the shares by dividing rather than by asserting. 0.20 divided by 0.28 is 0.714285 and so on, or 71.4 per cent to one decimal place. 0.08 divided by 0.28 is 0.285714 and so on, or 28.6 per cent to the same place. Both are rounded, the unrounded pair are 71.428 and 28.571 recurring, and at one decimal place they happen to add to exactly 100.0 rather than being made to. The charge explains most of the shortfall and not all of it, and any account that said a tracker falls behind by its costs would have stopped one step early.
| Step | The arithmetic | Result |
|---|---|---|
| Start | The unnamed broad index, stated year, invented figure | 12.40 per cent |
| Less | The scheme's charge of 0.20 per cent of its own assets a year | 0.20 points |
| Gives | What a scheme tracking it perfectly at that charge would have returned | 12.20 per cent |
| Actual | The Girnar Broad Market Index Fund, stated year, net | 12.12 per cent |
| Residual | 12.20 per cent less 12.12 per cent, everything the charge does not explain | 0.08 points |
| Check | 0.20 points of charge plus 0.08 points of residual, against 12.40 less 12.12 | 0.28 points, both ways |
Inside that 0.08 sit the things a tracker cannot avoid entirely: cash it holds rather than invests, the timing of money arriving and leaving, and the cost of dealing when the index it follows changes. No weight is available for any one of the three against another. How the shortfall is taken apart properly is a separate matter. The finished split is used here and nothing more is done to it.
The tracker's shortfall for the stated year was 0.28 points, being 0.20 of charge and 0.08 of everything else. How much of that 0.08 would an in kind route have saved?
How does any of this reach a tracker's shortfall?
Carefully, and only as a mechanism. A tracker falls short of its index by its charge and by a residual made of cash holdings, flow timingThe effect on a scheme of money arriving and leaving on the days that suit holders rather than the days that suit the portfolio. and the cost of dealing when the index changes. An in kind creation and redemption route touches exactly one of those three, and it touches it in a specific and limited way.
An in kind route moves the flow timing burden off the continuing holders and onto the participant. Who bears the burden changes, the burden itself does not stop existing, and the charge changes not at all. The participant delivering or receiving the holdings is the one dealing in the market now. The dealing still happened. Somebody still met that morning's prices. The scheme simply was not the one doing it, and the continuing holders were not the ones inside the pool while it happened.
Everything in the previous paragraph is a claim about location and nothing in it is a claim about size. The line between location and size is the sharpest line in the whole subject. The temptation is not to recommend a structure but to claim an efficiency, and the two are the same fault wearing different clothes. Moving a cost from one party to another is a different thing from removing it, and this record contains nothing that could measure either. So none of the 0.08 percentage points is re-attributed, no share of it is assigned to flow timing, and no figure is put on what an in kind route would have saved. A clean split invites the assumption that a second split is available, and no second split is.
Whether the index the tracker follows is computed on price alone or with income reinvested is not stated anywhere in this record. The distinction is a genuine unresolved check rather than a detail. The two versions of an index do not return the same figure.
Who reaches for this on a working day, and what do they do with it?
Three people, and none of them is reading it for interest. Somebody in a role like Sohail Merchant's, heading operations at an asset manager that runs an exchange traded scheme, reaches for it because the direct door is an operational commitment. Every block that comes in has to be checked, every basket has to be received and reconciled, the units have to be issued against it and the whole thing has to be recorded. The block size is not a marketing choice, it is the size at which that work is worth doing, and it is set within whatever conditions apply.
An analyst comparing two schemes uses the mechanism to know what a difference between a traded price and a value per unit means and what it does not. Knowing that a gap closes only to the point where closing it pays tells the analyst that a gap is an ordinary feature to be measured rather than an anomaly to be explained. The size of that gap is a scheme by scheme, day by day empirical question, answered by looking it up rather than by reasoning about it.
A household holding units of an exchange traded scheme uses the smallest and most useful part of it. The household knows it will never touch the direct door, that its sale is to another holder, and that the price it gets is a traded price rather than a value struck by the scheme. The one working habit that follows is worth more than the whole mechanism: at the moment of transacting, look at what the units are trading at and what the scheme says the underlying is worth, and notice the difference rather than assuming there is none.
None of the three can put a figure on that difference, or on what an in kind route saves, from anything set out here. The silence is a limit of the record and not a zero.
Last one. What does an in kind creation route change about a tracker's shortfall against its index?
Who sets the conditions, and where is the current position read?
SEBI sets the conditions on who may deal directly with a scheme, in what size and on what terms, along with the category conditions, the limits on what may be charged and the disclosure duties that attach to a scheme of any kind. Rules of that kind are revised, and a block size, minimum, limit, period or threshold reproduced from them would stop being merely dated and start being wrong. The current position is read at sebi.gov.in on the day it is needed.
Where units of an exchange traded scheme are held in dematerialised form, the mechanics of that holding are described by NSDL at nsdl.co.in and CDSL at cdslindia.com. Industry level material sits with the Association of Mutual Funds in India (AMFI) at amfiindia.com, a body that publishes rather than makes rules. Where any tax consequence of a transaction is in question, that is a matter for the tax authority at incometaxindia.gov.in, and no rate, classification or holding period is stated here.
A second market with different arrangements would be an addition to this account rather than a rewrite of it. The mechanism above is about how the supply of units can respond at all, and that logic does not depend on which regulator is naming the conditions.
References
| Source | Document | Where |
|---|---|---|
| Securities and Exchange Board of India | The conditions on who may deal directly with a mutual fund scheme, in what size and on what terms, together with the category conditions and the disclosure duties attaching to an exchange traded scheme | sebi.gov.in |
| National Securities Depository Limited | The mechanics of holding units in dematerialised form, which is how units of an exchange traded scheme are held | nsdl.co.in |
| Central Depository Services Limited | The same mechanics of dematerialised holding, published alongside the above | cdslindia.com |
| Association of Mutual Funds in India | Industry level material on scheme types and disclosure, with the site at which such material is published | amfiindia.com |
| The tax authority | Any tax consequence of buying, selling or redeeming units | incometaxindia.gov.in |
Girnar Asset Management Limited, the Girnar Large Cap Equity Fund, the Girnar Broad Market Index Fund, the unnamed broad index, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.