How ETFs Actually Work - No Paywall (The Cestrian Circle Newsletter)
Investor Briefing • Educational Note • The Creation/Redemption Mechanism, With Worked Examples In $QQQ and $XLE
The TL;DR
Many investors think an ETF works like a mutual fund: you send money to the issuer, they take it and buy the underlying. That is not what happens. When you buy $QQQ on your screen, its manager Invesco never sees your order and no stocks are purchased on your behalf. You are trading with another investor on an exchange, exactly as if you were buying a single stock.
The mechanism that keeps the ETF price pinned to the value of its underlying basket — and the mechanism that makes ETFs tax-efficient, cheap, and surprisingly resilient — is the creation/redemption process, operated in the background by a small group of large institutions called Authorized Participants. This note explains how it works, then walks through two concrete examples: $QQQ and $XLE.
DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Read our full disclaimer, here.
1. There Are Two Markets, Not One
An ETF exists in two places simultaneously. The first is the one you see: shares trading on an exchange, second by second, at whatever price a willing buyer and a willing seller can agree on. The second operates on a completely different clock and a completely different set of rules.
Call them the secondary market and the primary market.
The Secondary Market (Where Most Investors Live)
This is the public exchange — NASDAQ, NYSE Arca, Cboe BZX, and the rest. You place an order with your broker, your broker routes it to a market center, it matches against another investor or a market maker, and done. The ETF issuer — Invesco, State Street, BlackRock, whoever — is not involved. No shares are created. No shares are redeemed. The float of the ETF is unchanged. You and the counterparty have simply swapped ownership of existing shares.
This is the critical point that throws people off. On the secondary market, an ETF trades exactly like a stock. The issuer is a bystander.
The Primary Market (Where The Magic Happens)
This is where the ETF is actually constructed and maintained. Only a small number of pre-approved institutions can operate here. They are called Authorized Participants, or APs — typically big broker-dealers like Goldman Sachs, Citadel Securities, Jane Street, Virtu, Bank of America, and Susquehanna. An AP is the only entity that can walk up to the ETF issuer and transact directly in fund shares.
APs operate this way for themselves, to arbitrage away mispricings between the ETF's market price and the fair value of the basket it holds. This arbitrage is what keeps the ETF tracking its underlying index, and it is the single most important thing to understand about how ETFs work.
2. Creation: How New ETF Shares Come Into Existence
Let us say demand for QQQ spikes. Buyers outnumber sellers on the exchange, and the ETF's market price drifts above the fair value of the 100 Nasdaq stocks it holds — let us call this fair value the Net Asset Value, or NAV. A gap opens up. Say QQQ is trading at $540.20 but the underlying basket is worth $540.00.
This is where an AP steps in. The AP buys the 100 underlying stocks in the open market, in exactly the weights the index specifies — a basket the ETF issuer publishes every morning. The AP then delivers that basket of stocks, in kind, to QQQ's manager, Invesco. Invesco accepts the basket and, in exchange, issues the AP a block of brand-new QQQ shares, typically in units of 50,000 shares called a "creation unit".
The AP now owns 50,000 fresh QQQ shares that cost it the underlying basket price — say $27,000,000 in total — and it immediately sells them on the open market at the higher market price, say $27,010,000. It pockets roughly $10,000 for the round trip, less costs. That is the arbitrage profit.
Crucially, the act of selling those new shares into the market drives the ETF price down — and the act of buying the underlying basket drives those stocks up — until the gap closes and the arbitrage dies. That is why ETF prices hug their NAV.
The number of QQQ shares outstanding has just gone up by 50,000. No outside investor put money into Invesco. No portfolio manager made a buy decision. The ETF's holdings grew organically because an AP wanted to earn a tiny spread.
3. Redemption: The Same Movie, Played Backwards
Now imagine the reverse. Fear hits the market, QQQ is dumped on the exchange, and the ETF trades to a discount — $539.80 vs a basket worth $540.00. An AP can now buy 50,000 QQQ shares cheaply on the exchange, walk up to Invesco with them, and hand them over. Invesco cancels those shares and, in exchange, delivers the underlying basket of 100 stocks to the AP. The AP sells that basket in the market at the higher price and banks the spread.
The number of QQQ shares outstanding just fell by 50,000. The ETF shrank. Again, this happened without any portfolio manager at Invesco making a decision — the AP drove it, chasing an arbitrage profit.
This process, executed continuously across hundreds of APs and millions of trades per day, is why an ETF rarely trades far from its NAV, and why major ETFs can handle billions of dollars of flows without enormous amounts of manual effort.
The Cycle, Side by Side
| Step | Creation (ETF at Premium) | Redemption (ETF at Discount) |
|---|---|---|
| 1. Arbitrage Signal | ETF trades above NAV | ETF trades below NAV |
| 2. AP Action | Buys the underlying basket | Buys ETF shares on exchange |
| 3. Delivers to Issuer | Delivers basket, receives new ETF shares | Delivers ETF shares, receives basket |
| 4. AP Exit | Sells new ETF shares in market | Sells basket stocks in market |
| 5. Market Effect | ETF price falls, basket rises → gap closes | ETF price rises, basket falls → gap closes |
| 6. Share Count | Shares outstanding increase | Shares outstanding decrease |
Figure 1. The creation/redemption cycle, side by side.
4. Worked Example — $QQQ (Invesco QQQ Trust)
QQQ tracks the Nasdaq-100, a capitalization-weighted index of the 100 largest non-financial companies listed on Nasdaq. It is one of the most heavily traded securities in the world, typically turning over tens of billions of dollars of volume per day. The creation unit size is 50,000 shares.
A Typical Creation Day
Assume a run-of-the-mill session where tech sentiment is bullish and QQQ is in strong demand. By 10:00 AM, the ETF has drifted $0.20 above the live value of its basket. Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet and the rest of the 100 constituents have a total weighted value that — when you scale it down to a per-share level — comes out at $540.00. QQQ itself is printing $540.20.
Jane Street, one of QQQ's most active APs, spots the premium. Its systems fire off orders to buy the full basket of 100 Nasdaq-100 stocks in index weights, sized for a 50,000-share creation unit. That basket costs approximately 50,000 × $540.00 = $27,000,000, ignoring transaction costs. Jane Street delivers that basket in kind to Invesco's custodian (BNY Mellon). Invesco issues Jane Street 50,000 newly created QQQ shares. Jane Street sells those shares on Nasdaq at $540.20. Gross proceeds: $27,010,000. Gross P&L: about $10,000.
That is one creation unit on one ETF in one ten-minute window, done by one firm. Multiply by dozens of APs and thousands of such opportunities per day, and you begin to see why the machine stays oiled.
Why This Matters For QQQ Holders
Because creations and redemptions happen in kind — shares for shares, not cash for shares — Invesco almost never has to sell appreciated Nasdaq-100 stocks to meet redemptions. When an AP redeems, Invesco simply hands over the stocks. The embedded capital gains ride out of the fund with the AP. This is why large equity ETFs like QQQ can go years without distributing a capital gain, which is a structural advantage over an equivalent mutual fund.
For a taxable US investor in a top bracket, that distinction is worth tens of basis points a year in avoided drag. Over a decade of compounding, it is material.
What Can Go Wrong
The creation/redemption mechanism is robust, not bulletproof. In periods of extreme stress — think March 2020, or a single-name halt in a top-ten holding — APs can step away, arbitrage widens, and ETFs temporarily trade at discounts or premiums of 1-2%. For QQQ, where the underlying basket is deep, liquid, and trades on the same time zone as the ETF, this is rare and short-lived. It is worth knowing the mechanism has limits, but for a household-name ETF like this one, they are unlikely to bite you.
5. Worked Example — $XLE (Energy Select Sector SPDR Fund)
XLE is a very different beast. It is run by State Street, tracks the Energy Select Sector Index, and holds roughly 20-25 large-cap US energy names — ExxonMobil and Chevron alone are typically north of 35% of the fund, with the rest filled out by Schlumberger, ConocoPhillips, EOG, Marathon, and so on. It is concentrated, sector-specific, and sensitive to both the oil price and to a handful of very large individual companies. The creation unit for XLE is 50,000 shares, same as QQQ.
A Typical Redemption Day
Imagine WTI crude sells off 4% on an OPEC+ rumor. Energy stocks crater in sympathy. XLE gets dumped by sector-rotation funds and retail holders, pushing the ETF to a discount — say XLE prints $94.10 against a basket fair value of $94.30.
Citadel Securities, acting as an AP, buys 50,000 XLE shares on NYSE Arca at $94.10, outlay of $4,705,000. It delivers those shares to State Street. State Street cancels the shares and, in kind, delivers 50,000 shares' worth of the underlying basket — Exxon, Chevron, and the rest, in precise index weights. Citadel sells those individual stocks in the open market at a basket value of $4,715,000. Gross P&L: $10,000, minus transaction costs and hedging.
Every XLE share Citadel redeemed ceased to exist. The ETF's shares outstanding fell by 50,000. No one at State Street made a decision to reduce the fund's size — the market did, via the AP.
Why This Matters For XLE Holders
XLE's concentration in a small number of mega-cap names means the underlying basket is extremely liquid — Exxon trades billions of dollars a day on its own — so the arbitrage mechanism works cleanly. You are unlikely to see XLE drift far from NAV outside of genuine market stress.
However, because XLE holds a smaller number of names than QQQ, the tax-efficiency story is even stronger. APs can redeem shares in kind using specific lots of the most appreciated underlying stock, letting State Street flush low-basis positions out of the fund without ever selling them. This is sometimes called "heartbeat" trading — a perfectly legal use of the ETF structure that has given concentrated sector ETFs remarkable tax efficiency compared to equivalent mutual funds.
What Can Go Wrong
Two things to watch with a fund like XLE. First, single-name risk — if Exxon or Chevron halts (a regulatory investigation, a major incident), the arbitrage process can wobble because the AP cannot reliably price the basket. Second, commodity-driven gap risk — on a weekend oil-market shock, XLE can open Monday at a wide premium or discount to the basket because energy stocks themselves are repricing. The AP mechanism is good at closing gaps during the trading day. It cannot prevent them from opening.
6. What You Should Take Away
ETFs Are Not Mutual Funds
A mutual fund takes cash from investors and the manager buys stocks. An ETF lets market participants swap baskets of stock for ETF shares and back, with you trading the result on an exchange. The plumbing is completely different, and the plumbing determines the economics.
The Issuer Is Not The Counterparty
When you buy QQQ or XLE, Invesco and State Street do not sell you the shares. An exchange counterparty does. The issuer's role is to make the creation/redemption process available to APs and to manage the underlying portfolio against the index. That is it. Understanding this changes how you think about liquidity, execution, and the tracking of the fund.
The Arbitrage Is The Product
The reason you pay a 0.20% fee on QQQ and a 0.09% fee on XLE and still get tight tracking, deep liquidity, and tax efficiency is the Authorized Participant arbitrage running in the background. A handful of large firms compete for fractions of a cent per share, and that competition is what underwrites your experience as a retail or professional holder. When the arbitrage breaks, so does the ETF. Most of the time, it does not break — and that is the structural story of the ETF industry.
Liquidity Is A Two-Layer Question
The liquidity of an ETF is not just its own volume on the screen — it is the liquidity of the underlying basket. A thinly traded ETF on highly liquid underlyings (like a new S&P 500 wrapper) can be traded in size through creation, even if the ETF itself looks illiquid. Conversely, a popular ETF on thinly traded underlyings (emerging-market small caps, for example) can seize up even though the screen looks busy. For QQQ and XLE, both the ETF and the underlyings are deep, so this is a non-issue. For exotic ETFs, it is the first thing to check.
Cestrian Capital Research, Inc — 20 April 2026.
Sources: SEC Investor Bulletins on ETFs; Invesco QQQ prospectus and product page; State Street SPDR XLE prospectus and fact sheet; ICI ETF primer; BlackRock "iShares ETF Education" materials; Claude CoWork.