ETFs: An inside Look at the Construction

" ...

When investors want to sell their ETF holdings, they can do so by one of two methods. The first is to sell the shares on the open maket. This is generally the option chosen by most individual investors. The second option is to gather enough shares of the ETF to form a creation unit and then exchange the creation unit for the underlying securities. This option is generally only available to institutional investors due to the large number of shares required to form a creation unit. When these investors redeem, the creation unit is destroyed and the securities are turned over to the redeemer.

The beauty of this option is in its tax implications for the portfolio. We can see these tax implications best by comparing the ETF redemption to that of a mutual fund redemption. When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by a tax burden because to redeem the shares, the mutual fund may have to sell the securities it holds, realizing the capital gain, which is subject to tax. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis. So even if the portfolio has lost value that is unrealised, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains.

ETFs minimize this scenario by paying large redemptions with shares of stock. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer. This increases the cost basis of the ETF's overall holdings, minimizing capital gains for the ETF. It doesn't matter to the redeemer that the shares it receives have the lowest cost basis because the redeemer's tax liability is based on the purchase price it paid for the ETF shares, not the fund's cost basis. When the redeemer sells the shares of stock on the market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios. "

--> Full text reads as in the following link:
http://investment.aimg.se/sve/globala%20nyheter/PDF/Construction%20of%20ETF.pdf