1. An ETF Manager Files Their Plans with the Securities and Exchange Commission (SEC)
The ETF process begins first with the ETF Manager, also known as the sponsor. The sponsor and their team work on creating a plan for their ETF. The plan includes items such as the approach of the ETF and the kind of securities the ETF will invest in. Once the plan is completed, it is filed to the SEC, who will review the plan and either approve or disapprove it. Once the plan is approved, the sponsor can move on to acquiring the necessary securities to bring the ETF to life.
2. The ETF Manager Forms an Agreement with a Market Maker
To get the securities necessary for the ETF, the sponsor will work with a market maker, also known as an authorized participant. The authorized participant is the one who will get the underlying securities necessary to form ETF creation units, which are blocks of new ETF shares. A creation unit block typically ranges from 25,000 to 600,000 shares.
Once the sponsor forms an agreement with the authorized participant, the authorized participant will purchase the underlying securities necessary to create the ETF creation units, or they will borrow the securities, often from a pension fund. The underlying securities are then placed in a trust, a fiduciary arrangement that allows a party to hold assets on behalf of a beneficiary.
3. The Market Maker Sells the ETF Shares on the Open Market
The ETF creation units are formed in the trust. For the work that the authorized participant has done, the sponsor will grant them ETF creation units equal in value to the underlying securities. That is a fair-value basis exchange. There are no tax implications. Now that the authorized participant has the ETF creation units in their possession, they will sell them for profit to the public on the open market just like stocks. You can think of it as an IPO for an ETF.