ETFs - Replication, Creation Units and Tracking Error

By EC Assets Research Team, Index & Vehicle Research · Published 16 October 2026

ETFs: An exchange-traded fund (ETF) is a pooled investment vehicle whose shares trade on a stock exchange like an individual stock. Most ETFs hold a basket of securities designed to track a published index - a mechanism called the creation/redemption process keeps the share price tightly anchored to net asset value.

What ETFs Are

An exchange-traded fund is a pooled investment whose shares trade on a stock exchange throughout the day. Most ETFs track an index by holding its securities, either all of them or a representative sample; some use swaps to obtain the index return. Each fund publishes the value of its holdings, its net asset value, and its market price is kept close to that value by the mechanism that defines the structure.

ETFs are used to gain broad market exposure cheaply, to park cash, to adjust allocations quickly and to reach markets that are hard to access directly, such as some bonds and commodities.

How It Works

Authorised participants, usually large banks and market makers, can create new ETF shares by delivering a basket of the underlying securities to the fund, or redeem shares by returning them for the basket. If the ETF trades above the value of its holdings, they buy the basket, create shares and sell them; if it trades below, they buy shares and redeem them. These trades push the price back towards the value of the holdings until the gap is smaller than the costs of doing them.

Liquidity therefore has two layers. Trading volume in the ETF itself matters for small orders; for large orders, what matters is the liquidity of the underlying basket, because authorised participants can create as many shares as they can source securities for. Petajisto (2017) shows that premiums and discounts are small for ETFs holding liquid securities and larger for those holding illiquid or foreign assets, where the reported value itself is stale.

The structure also has costs. The fund's fee, the cash it holds between dividends, trading when the index changes and, for some funds, sampling create a tracking difference against the index. Securities lending income can offset part of it. Because redemptions are usually made in kind, US ETFs rarely distribute capital gains, which makes them more tax-efficient than many mutual funds; the tax considerations entry covers the wider rules.

Worked Example

An ETF has a value of 500.00 per share but trades at 501.50, a 0.30 percent premium. An authorised participant buys a basket for one creation unit of 50,000 shares for 25,000,000 dollars, receives 50,000 new shares and sells them for 25,075,000 dollars. With a creation fee of 3,000 dollars and trading costs of 2 basis points on the basket, it pays costs of 8,000 dollars, a profit of 67,000 dollars. Creation continues until the premium falls to about 3.2 basis points, where the trade no longer covers its costs.

Over long periods the costs show in the tracking difference. From 2011 to 2025, SPY, the oldest US-listed S&P 500 ETF, returned 13.95 percent a year against 14.06 percent for the index with dividends reinvested, a tracking difference of -11.7 basis points a year. The fund's fee is 0.0945 percent; the rest reflects the cash it holds between receiving dividends and paying them out, which its trust structure does not allow it to reinvest.

Yahoo Finance adjusted closes for SPY and the S&P 500 Total Return index, dividends reinvested on ex-dates; based on market prices, so small premiums and discounts add to the measured tracking error.

The calendar-year difference ranged from -26.2 basis points in 2019 to +3.8 in 2016, and the tracking error, measured on monthly returns, was 29 basis points. Small as these are, they compound: 10 million dollars invested at the end of 2010 ended about 1,101,000 dollars less than the same amount in the index by the end of 2025.

When It Applies (and Limitations)

Stress tests the arbitrage. When the underlying market seizes up, authorised participants cannot hedge or source baskets at reported prices, and ETF prices move away from stale reported values; bond ETFs showed this in March 2020.

Market structure events. On 24 August 2015, many US ETFs traded far below the value of their holdings in the first hour of trading, as opening delays and trading halts in underlying stocks left prices without reliable reference values.

Synthetic replication adds counterparty risk. Swap-based ETFs depend on their swap counterparties, within collateral limits set by regulation.

Effects on underlying markets. Ben-David, Franzoni and Moussawi (2018) find that higher ETF ownership raises the volatility of the stocks held.

Why It Matters for Institutional Investors

Low-cost exposure. Large index ETFs offer broad exposure at costs of a few basis points a year, competitive with futures for longer holding periods and useful for asset allocation changes and cash equitisation.

Execution. Large trades can be priced against the underlying basket through authorised participants or liquidity providers, rather than against displayed ETF volume, a point covered under market microstructure.

Due diligence. Tracking difference over several years, structure, securities lending policy and the liquidity of the holdings matter more than the headline fee.

Stress planning. Investors should expect ETF prices in less liquid asset classes to diverge from reported values in stress, and decide in advance whether to trade at those prices.

References

1. Madhavan, A. (2016). Exchange-Traded Funds and the New Dynamics of Investing. Oxford University Press.
2. Petajisto, A. (2017). Inefficiencies in the Pricing of Exchange-Traded Funds. Financial Analysts Journal, 73(1), 24-54.
3. Ben-David, I., Franzoni, F., & Moussawi, R. (2018). Do ETFs Increase Volatility? Journal of Finance, 73(6), 2471-2535.
4. Gastineau, G. L. (2010). The Exchange-Traded Funds Manual (2nd ed.). Wiley.