In-kind creation

In-kind creation is the most common form of the broader creation and redemption process, in which new ETF shares are created using an actual basket of the fund's underlying securities, delivered directly to the fund by an authorized participant, rather than by delivering cash that the fund would then have to use to buy those securities itself. The equivalent process in reverse, in-kind redemption, works the same way, an authorized participant hands back ETF shares and receives the underlying securities directly instead of cash.

This in-kind structure is what gives ETFs a meaningful tax advantage over mutual funds. When a mutual fund needs to raise cash to meet redemptions, it typically has to sell securities from the portfolio, which can trigger a taxable capital gain that gets passed on to all remaining shareholders through a capital gains distribution. An ETF using in-kind redemption instead delivers securities directly to the authorized participant, which is generally not treated as a taxable sale by the fund, so the fund's remaining shareholders are not stuck absorbing a tax bill from that transaction.

Not every ETF uses in-kind creation and redemption for every transaction, some ETFs, particularly those holding certain fixed income or international securities, use partial or full cash creation and redemption instead, which can reduce some of this tax efficiency advantage. Still, the availability of in-kind creation across most equity ETFs is one of the central structural reasons ETFs have built a reputation as a more tax efficient wrapper than comparable mutual funds.