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It is known that: When the price of an ETF is lower than its NAV (i.e. Net Asset Value, the value of underlying securities, per ETF share), the Authorized Participants essentially buy ETF shares from the market, then they exchange with the ETF company ETF shares with the shares of the underlying securities. This is an "in-kind" transaction, so nobody pays taxes. At this step, usually the fund company provides to the Authorized Participants the batch of shares that have the lowest cost basis (i.e. the shares that were bought at the lowest price), which are the ones that would generate more capital gain taxes. Then the Authorized Participants sell the securities on the market, get the cash and make a risk free profit (arbitrage) based the difference ETF price and NAV. Selling the securities on the market tends to lower the ETF NAV, buying the ETF on the market tends to increase ETF price. The process continues until the difference between ETF price and NAV is so small that makes this process not profitable anymore for the Authorized Participants. This process is necessary to align the ETF price to the NAV (often called "creation and redemption" mechanism of the ETF's)

Question: In the scenario above, the Authorized Participants sell the securities with low cost basis on the market, therefore they end up paying taxes on that transaction. Clearly there is a limit to the amount of taxes the Authorized Participants are willing to pay. If the taxes are too high, the taxes may make the arbitrage mechanism unprofitable for the Authorized Participants. So what are the "rules of the game" between the fund company and the Authorized Participants in this regard? Maybe the Authorized participants must always accept any cost basis from the fund company even if this would be unprofitable for them?

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  • Why do you assume the ETF is willing to exchange its shares for the component equities? That is certainly not a "known".
    – keshlam
    Sep 23 at 15:37
  • it is necessary to align the ETF price to the NAV
    – Fuzzy
    Sep 23 at 19:11
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    @Fuzzy they may hold the ETF shares and sell them back to the market when the price exceeds the NAV. They don't have to immediately redeem them, and in fact they don't specifically for that reason (to lower the price if it goes above NAV).
    – littleadv
    Sep 23 at 19:35
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    Authorized participants make money on the arbitrage. They are not paying taxes on capital gains from selling 'appreciated' shares. Sep 25 at 0:40
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    @keshlam "willing to exchange its shares for the component equities" is part of the definition of ETF. Otherwise it would be a CEF (Closed End Fund), which is also exchange-traded, but doesn't permit creation and redemption of new shares by APs.
    – Ben Voigt
    Sep 28 at 15:04

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