Directors of ETFs

Directors of Exchange-Traded Funds (ETFs), like mutual fund directors, have a fiduciary duty to the funds and serve to protect the interests of fund shareholders. An ETF is a pooled investment vehicle with shares that can be bought or sold throughout the day on stock exchanges at market-determined prices. Investors may buy or sell ETF shares through a broker, just as they would the shares of a publicly-traded operating company. 

How ETFs Work

ETFs are investment companies that combine features of traditional mutual funds with the ability to trade throughout the day on an exchange. Like mutual funds, ETFs hold a diversified portfolio of assets, but their shares are bought and sold by investors on stock exchanges at market-determined prices. 

Primary and Secondary Markets

ETF shares are traded in two distinct markets.

  • Primary market:
    A limited group of large financial institutions—known as authorized participants (APs)—interact directly with the ETF to create and redeem shares in large blocks called creation units. 
  • Secondary market:
    Most investors buy and sell ETF shares on a stock exchange through a broker, just as they would trade individual stocks. 

This distinction is central to understanding how ETFs operate.

Creation and Redemption Process

The creation and redemption mechanism is the core feature that differentiates ETFs from other investment funds.

  • Creation:
    An AP assembles a specified “basket” of securities (and/or cash) that reflects the ETF’s portfolio and delivers it to the ETF. In return, the ETF issues a creation unit—a large block of ETF shares—which the AP may then sell on an exchange. 
  • Redemption:
    The process works in reverse. An AP returns ETF shares to the fund and receives a corresponding basket of securities or cash, and the shares are removed from circulation. 

Retail investors do not transact directly with the ETF in this process; instead, they trade ETF shares on the exchange.

Pricing and Market Efficiency

APs use arbitrage and the creation and redemption process to keep ETF share prices aligned with the underlying value of the fund.

  • ETF share prices are determined by supply and demand in the secondary market. However, the ability of APs to create and redeem shares provides a mechanism that helps ETF prices remain close to the value of the fund’s underlying portfolio (net asset value, or NAV). 
  • When market prices deviate from the value of the underlying assets, APs may engage in arbitrage by creating or redeeming shares, which can help realign the market price with underlying value.

Independent Director Oversight Responsibilities

Although ETF independent directors have substantially similar responsibilities as directors of traditional mutual funds, there are important differences and distinct areas of focus due to the structure of the product. Independent directors of ETFs should gain a fundamental understanding of: 

  • The structure, organization, and operation of ETFs. Independent directors should have a working knowledge of the market participants and their respective roles that enable ETFs to operate. 
  • The role and oversight responsibilities of independent directors overseeing ETFs. While ETF directors have the same general oversight responsibilities as the directors of other registered funds, ETFs are subject to the provisions of the SEC’s ETF rule, exchange-imposed rules, and are required to oversee service providers unique to the ETF market. 
  • ETF market and policy developments. The ETF marketplace is evolving rapidly with product launches and potential regulatory changes that lead to greater innovation, while potentially expanding board oversight responsibilities. ETF directors should keep abreast of these developments. 

Key IDC Resources

As a member, if you have not already logged in to the IDC website, please do so in order to view all of the resources available. Click here to login.

Key ICI Resources

 

Additional Resources

SEC