ETFs Under the Hood: The Primary and Secondary Markets
May 04, 2026
Regardless of the investment objective, the important thing to remember is that each ETF is made up of different individual pieces. The ability to assemble, break down, and reassemble those individual pieces — called the creation and redemption processes — is what drives both the liquidity and the potential tax benefits of ETFs.
"ETFs offer investors key advantages over mutual funds: intra-day trading, higher daily transparency, and a unique creation/redemption mechanism that enhances both liquidity and tax efficiency."
ETFs: A Quick Recap
ETFs offer investors important advantages compared to mutual funds. First, an investor who's looking to buy or sell a particular ETF doesn't have to wait until the end of the trading day to complete a transaction — ETFs can be bought and sold whenever the market is open. In addition, ETFs also sport higher levels of daily transparency than mutual funds, as most ETFs publish their underlying holdings daily.
After a buyer (retail or institutional) places an order for an ETF, there are multiple ways traders can source the shares for that end-investor's account. ETF traders can operate in two markets: the secondary market (buying and selling existing shares on an exchange) or the primary market, where ETF share creation and redemption orders take place.
ETFs Under the Hood: The Primary & Secondary Market Players
Understanding who does what in the ETF ecosystem is essential. There are four key players:
Investors
From individuals to institutions, investors are the end-buyers or end-sellers of ETFs.
ETF Issuers
Issuers sponsor ETFs, list them on an exchange (such as Nasdaq), and manage the fund. When a new ETF comes to market, it's funded with seed capital used to buy the securities forming the initial ETF shares.
Exchanges
Regulated platforms like Nasdaq where companies/issuers can list their shares, and traders meet to buy and sell. Exchanges host the secondary market.
Authorized Participants (APs)
APs are allowed to place creation and redemption orders directly with ETF issuers, passing underlying holdings to receive created ETF shares, or redeeming existing shares for the underlying holdings. APs are typically banks or self-clearing broker-dealers.
Market Makers
ETF Market Makers (MMs) are trading firms that specialize in facilitating the buying and selling of ETF shares on the exchange, offering ongoing daily access. Market Makers buy when investors want to sell and sell when investors want to buy — profiting on the spread.
How Is This Different Than Mutual Funds?
ETFs and mutual funds can similarly create and redeem shares directly with the issuer, but ETFs unlock an additional type of ability to trade shares by being listed on the exchange. The amount of ETF shares being bought or sold on the exchange is an ETF's secondary market trading volume, or average daily volume (ADV).
The primary and secondary markets comprise ETFs' layers of liquidity: the first layer emerging from pre-existing ETF shares' trading volume, and the second arising from the ability to create or redeem ETF shares. While every mutual fund transaction results in the purchase or sale of the underlying holdings, only creations and redemptions result in a change to shares outstanding for an ETF.
💡 ETF Liquidity Is Deeper Than It Appears
An ETF's Average Daily Volume (ADV) is only a portion of its total available liquidity. Total liquidity = ADV on the exchange PLUS the trading volume of the ETF's least-traded underlying holding. If an investor wants to buy more than an ETF's daily volume, a Market Maker can simply use an AP to create new shares in the primary market.
A Primary Market Creation Example
When an investor purchases ETF shares, the delivered shares can be sourced from pre-existing ETF volume via the secondary market, or new shares created from underlying holdings via the primary market.
Think of it like a farmer's market stand selling corn bushels. The salesperson can source bushels from the existing supply at the stand (secondary market), or have fresh bushels made from the cornfield (primary market). If the cornfield is plentiful — or the underlying holdings have high trading volumes — it's very easy to create new ETF shares on demand.
"If a large investor wants to purchase far more of an ETF than its average daily volume, the Market Maker simply uses an AP to create the required ETF shares in the primary market — just like the market stand worker fetching extra bushels straight from the farm."
Two-Part Tradability Benefits
APs play a vital role in maintaining ETF pricing efficiency. If an ETF's price is higher than its Net Asset Value (NAV), an AP will buy the underlying holdings, pass them to the issuer to create ETF shares, and sell those shares at a premium on the exchange — profiting on the difference and bringing the ETF's price back in line with its underlying value.
Conversely, if an ETF is trading below NAV, the AP buys cheap ETF shares on the secondary market and redeems them in the primary market, profiting on the sale of the underlying holdings — which brings the ETF's price back up.
ETFs with greater volume typically have narrower bid-ask spreads. The Bid is the highest price at which a market participant is willing to buy, while the Ask is the lowest price a seller is willing to accept. A narrow spread means buyers and sellers are in close alignment on the ETF's value.
The In-Kind Advantage: Tax Efficiency
It's important to note that the AP and ETF issuer aren't selling shares back and forth — they're passing them in and out of the fund 'in-kind' through the creation and redemption process. This ability to create and redeem ETF shares in-kind is what makes ETFs much more tax-efficient than mutual funds.
For mutual funds, every time a shareholder redeems, the underlying securities must be sold — generating taxable events that accumulate throughout the year. At year-end, all investors in the fund may receive a 'Capital Gains Distribution' representing those gains.
ETFs, by contrast, allow the Issuer and the AP to minimize taxable events by exchanging ETF shares and underlying securities in-kind when possible, making capital gains distributions far less likely. An ETF investor's capital gains are not influenced by other investors entering or exiting the fund.
Always consult a tax professional for specific advice or recommendations regarding your personal tax situation.
Key Term
Arbitrage
The process of buying in one market and selling in another to profit from price discrepancies. Arbitrage by Market Makers and Authorized Participants helps to keep the price of an ETF close to its Net Asset Value (NAV).
Bottom Line
It's important for investors to understand how the primary and secondary markets power many of the unique benefits of ETFs. The ETF ecosystem is vast, with multiple participants tasked with providing access, liquidity, and fair pricing. Add tax efficiency into the mix, and it's easy to see why ETFs have become the vehicle of choice for so many investors.