ETFs can provide investors with superior liquidity, lower costs and greater tax efficiency relative to some other investment vehicles. While ETFs clearly don’t hold some mysterious magical ability, the primary market mechanism is, in part, what enables these unique vehicles to offer such attractive characteristics for investors. Our primer below breaks it down.

The Workings of the Primary Market
ETF shares are created and redeemed in the primary market between the ETF and an Authorized Participant (AP). APs, large financial institutions with contractual ability to transact directly with an ETF, provide a large portion of underlying liquidity in the ETF market and increase market transparency by keeping ETF prices close to their net asset values.

Share creation transactions are conducted in-kind1 by exchanging ETF portfolio securities for ETF shares. As a result, the AP bears the trading costs for purchasing portfolio securities (in a share creation transaction), or selling portfolio securities received (in a share redemption transaction) in the open market. Since redemption trades are executed in-kind, the Internal Revenue Code provides for the ETF to not realize a taxable gain/loss from such transactions – enabling ETFs to operate with lower costs and greater tax efficiency.

As illustrated below, trading in the primary market exists on an over-the-counter basis between the AP and ETF issuer, and is facilitated through the ETF’s distributor, custodian and transfer agent. Our graphic shows how the AP works with an ETF issuer (in this case, for a creation order) with the underlying securities delivered from the AP to the ETF, and the AP receiving newly created ETF shares in exchange. Conversely, for a primary market redemption order, the AP would deliver existing ETF shares and receive the underlying ETF portfolio securities from the ETF in exchange.

A Primary Market Creation Order
Primary Market Creation Order - Authorized Participants to ETF Via Distributor/Transfer Agent and Custodian to Newly Created ETF Shares

How Is True ETF Liquidity Determined by the Primary Market?
Appreciating the true liquidity for an ETF depends upon the liquidity of the underlying portfolio securities that an ETF holds. If that basket of securities is liquid day to day, this makes the ETF itself liquid. Ultimately, an ETF is as liquid as its least liquid underlying holding. However, since ETF shares can be continually created to meet demand, the ETF’s average trading volume and total assets do not fully determine liquidity.

The graphic below shows the hierarchy of ETF liquidity: The greatest liquidity levels are at the bottom of the pyramid, with secondary market orders on top and primary market orders on the bottom. ETF shares that are traded throughout the day in relatively small order lots occur on the secondary market; these are broker-facilitated transactions between ETF investors and market makers. Any ETF share trading on the secondary market has been previously created in the primary market and will change hands from investor to investor, based on demand.

However, if a very large lot order were to be executed, it would likely trigger a transaction in the primary investor and the available liquidity would be the result of the underlying portfolio securities that make up the creation basket.

The Hierarchy of ETF Liquidity
Two section pyramid. The smaller top piece in purple is Secondary Market with Broker-Dealer Supply and Demand, and Market Maker Inventory in it. The bottom piece in blue is Primary Market with Portfolio Security Liquidity in it.

How Are ETF Shares Priced in the Primary and Secondary Market?
The primary benefit for an AP to transact in the primary market is the arbitrage opportunity that may arise when the ETF share price differs from the underlying security basket value. An arbitrage opportunity is a risk-free way for the AP to realize a profit. (Beyond the potentially risk-free profit that an AP may generate, participating in the primary markets helps APs maintain strong working relationships with market makers and ETF issuers.)

Figure A below shows ETF shares priced at a premium. The ETF is trading in the market at $25 and the value of the underlying security basket is $20. The AP steps in to buy the basket of securities at $20 in exchange for ETF shares in the primary market. The AP then immediately sells the ETF shares in the secondary market to realize a profit of $5, which, in turn, puts downward price pressure on the ETF in the secondary market.

Figure A. Premium
First of three mini charts. Security Basket within all three is $20. For this one, Premium, ETF Shares are $25.

Figure B shows ETF shares priced at a discount. The ETF is trading in the market at $15 and the value of the underlying security basket is $20. Here, the AP purchases ETF shares in the secondary market, creating upward price pressure on the ETF shares in the secondary market. The AP then immediately redeems these ETF shares on the primary market and receives the underlying basket of securities worth $20. The AP can now sell these underlying securities on the open market, realizing a profit of $5.

Figure B. Discount
Second of three mini charts showcasing Discount. Security Basket within all three is $20. For this on, Discount, ETF Shares are $15.

In cases of both premium and discount pricing, the process could be repeated until there is no arbitrage opportunity available. As illustrated in Figure C, the ETF is priced equivalent to its underlying security basket value, which is considered a price equilibrium where the ETF shares are fairly valued in the market.

Figure C. Equilibrium
Third of three mini charts. Security Basket within all three is $20. For this one, Equilibrium, ETF Shares are $20.

An understanding of how efficiently ETFs can provide liquidity and pricing in line with intrinsic value, even in volatile market environments, shows the importance of the primary market mechanism. While we know there is nothing magic about investments – rather it’s about diligence, investment prowess, and consistency – the behind-the-scenes workings of the primary market may enable ETFs to enhance an investor’s portfolio.

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1 An in-kind transaction involves a payment made in the form of securities rather than cash.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

Investing involves risk, including the risk of loss. Before investing, consider the fund’s investment objectives, risks, charges, and expenses. Visit for a prospectus or a summary prospectus containing this and other information. Read it carefully.

ETF General Risk: ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF's net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

Semi-transparent ETFs are different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. This ETF will not. This may create additional risks for your investment. For example: You may have to pay more money to trade the ETF’s shares. This ETF will provide less information to traders, who tend to charge more for trades when they have less information. The price you pay to buy ETF shares on an exchange may not match the value of the ETF’s portfolio. The same is true when you sell shares. These price differences may be greater for this ETF compared to other ETFs because it provides less information to traders. These additional risks may be even greater in bad or uncertain market conditions. The ETF will publish on its website each day a “Proxy Portfolio” designed to help trading in shares of the ETF. While the Proxy Portfolio includes some of the ETF’s holdings, it is not the ETF’s actual portfolio. The differences between this ETF and other ETFs may also have advantages. By keeping certain information about the ETF secret, this ETF may face less risk that other traders can predict or copy its investment strategy. This may improve the ETF’s performance. If other traders are able to copy or predict the ETF’s investment strategy, however, this may hurt the ETF’s performance.

Authorized Participant Concentration Risk: Only an authorized participant (“Authorized Participant”) may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that act as Authorized Participants, none of which are or will be obligated to engage in creation or redemption transactions. To the extent that these institutions exit the business or are unable to proceed with creation and/or redemption orders with respect to the Fund and no other Authorized Participant is able to step forward to create or redeem Creation Units, Fund shares may trade at a discount to NAV and possibly face trading halts and/or delisting. The Fund’s novel structure may affect the number of entities willing to act as Authorized Participants, and this risk may be exacerbated during times of market stress.

Trading Issues Risk: Trading in Fund shares on the NYSE Arca may be halted in certain circumstances. If 10% or more of the Fund’s Actual Portfolio does not have readily available market quotations, the Fund will promptly request that the NYSE Arca halt trading in the Fund’s shares. Such trading halts may have a greater impact on the Fund compared to other ETFs due to its lack of transparency.

Predatory Trading Practices Risk: Although the Fund seeks to benefit from keeping its portfolio holdings information secret, market participants may attempt to use the Proxy Portfolio and related Proxy Portfolio Disclosures to identify the Fund’s holdings and trading strategy. If successful, this could result in such market participants engaging in predatory trading practices that could harm the Fund and its shareholders.

Premium/Discount Risk: Shares of the Fund are listed for trading on the NYSE Arca, Inc. (the “NYSE Arca”) and are bought and sold in the secondary market at market prices that may differ from their most recent NAV. The market value of the Fund’s shares will fluctuate, in some cases materially, in response to changes in the Fund’s NAV, the intraday value of the Fund’s holdings, and the relative supply and demand for the Fund’s shares on the exchange.
Proxy Portfolio Structure Risk: Unlike traditional ETFs that provide daily disclosure of their portfolio holdings, the Fund does not disclose the daily holdings of the Actual Portfolio. Instead, the Fund discloses a Proxy Portfolio that is designed to reflect the economic exposure and risk characteristics of the Fund’s Actual Portfolio on any given trading day. Although the Proxy Portfolio and Proxy Portfolio Disclosures are intended to provide Authorized Participants and other market participants with enough information to allow them to engage in effective arbitrage transactions that will keep the market price of the Fund’s shares trading at or close to the underlying NAV per share of the Fund, while at the same time enabling them to establish cost-effective hedging strategies to reduce risk, there is a risk that market prices will vary significantly from the underlying NAV of the Fund.

Active ETF: Unlike typical exchange-traded funds, there are no indexes that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Diversification does not guarantee a profit or protect against a loss. Equity Securities Risk: Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Foreign Securities Risk: Foreign securities may involve heightened risk due to currency fluctuations. Additionally, they may be subject to greater political, economic, environmental, credit, and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. Currency Risk: Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund’s investments to decline. Small and Mid-Cap Stocks Risk: Investments in small and midsize companies can be more volatile than those of larger companies.

ALPS Distributors, Inc. is the distributor for the Natixis Loomis Sayles Short Duration Income ETF, the Natixis Vaughan Nelson Mid Cap ETF, the Natixis Vaughan Nelson Select ETF, and the Natixis US Equity Opportunities ETF. Natixis Distribution, LLC is a marketing agent. ALPS Distributors, Inc. is not affiliated with Natixis Distribution, LLC.

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