Redemption Mechanism

A redemption mechanism (also called a creation/redemption mechanism) is deployed by market makers to ensure the price of an ETF does not fluctuate too far away from its NAV.

The process of creation and redemption involves a few large specialized investors, known as authorized participants (APs). The APs are financial institutions which can only trade directly with the ETF issuer. This is why they are able to arbitrage the difference between the ETF shares’ market price and its NAV. When the AP notices that the ETF shares are overpriced (above the fund’s NAV), it purchases gold bullion and sells ETF shares in the open market. Conversely, if the ETF shares are undervalued (below the fund’s NAV), the AP buys the ETF shares, redeems them for gold bullion which can be resold. In both scenarios, the AP’s actions drive the ETF’s share price toward the fair value (fund’s NAV). Although the arbitrage process is not perfect, it works reasonably well. As the chart GLD vs. NAV below shows, the GLD share price is trading at fair value most of the time.

Chart 1: The price of GLD (green line) and the SPDR Gold Trust’ Net Asset Value (red line) for the last twelve months.

Gold redemption mechanism in GLD ETF

The redemption mechanism implies that the changes in the ETF’s holdings of gold bullion result only from arbitrage. Normally, changes in gold prices do not require any change in the ETF’s inventory. Only when the ETF’s share price deviates from the NAV – which usually occurs only as consequence of aggressive buying (selling) of shares triggered by price rallies (declines) lasting for a while – gold bullion flows into or out the ETFs. Hence, the correlation between the ETF flows and the price of gold results from a normal arbitrage process (occurring via the redemption mechanism) which underlies all ETFs. Those who claim that gold outflows from the ETFs prove some sort of manipulation may not understand how the ETFs work. Those who argue that selling (buying) gold from (for) the ETFs’ inventories drives the price of gold likely confuse effects with cause. In fact, the flows of bullion into (out of) the ETFs’ holdings are caused by changes in sentiment among ETF traders happening after changes in gold prices.

We encourage you to learn more about gold – not only how the redemption mechanism keeps the share prices of gold ETFs in line with the particular fund’s NAV, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.