In-kind redemption is a process that lets a large institutional investor exit a position in an ETF or mutual fund by receiving a slice of the fund’s actual portfolio securities instead of cash. The fund hands over stocks or bonds share-for-share rather than selling holdings to fund a cash payout. Retail investors never do this themselves, but the mechanism quietly drives the tax efficiency of nearly every ETF they own.
Who Actually Redeems In-Kind
Only Authorized Participants can redeem shares directly with an ETF issuer. These are large broker-dealers or market-making firms that sign a contract with the fund’s distributor giving them exclusive access to the primary market. If you buy an ETF through a brokerage account, you’re trading on a stock exchange with another investor. You never touch the fund itself.
That distinction is what makes the whole system work. When an ETF’s market price drifts above or below the value of its underlying portfolio, an Authorized Participant can create or redeem shares in-kind and profit from the gap until the prices converge. The arbitrage keeps the price on your screen close to what the portfolio is actually worth.
How the Basket Exchange Works
Every trading day, an ETF publishes a redemption basket listing the exact securities and quantities it will deliver in exchange for a block of fund shares. To redeem, an Authorized Participant has to accumulate a full creation unit’s worth of ETF shares from the secondary market. Creation units typically run between 25,000 and 100,000 shares, depending on the fund.
Not every redemption uses the standard published basket. Under SEC Rule 6c-11, funds may also use custom baskets that differ from the standard basket in composition or weighting. A custom basket might overweight specific holdings the portfolio manager wants to remove. Funds that use custom baskets have to keep written policies covering how each basket is built, who reviews it for compliance, and how the fund prevents one Authorized Participant from getting preferential treatment over another. Every basket exchanged must be logged, including the identity of each security, its quantity and weight, whether the basket was custom, and the participant on the other side. Records have to be preserved for at least five years, with the first two years kept in an easily accessible location.
Once the participant submits its redemption order, settlement runs through the National Securities Clearing Corporation, which acts as the central counterparty and guarantees delivery on both sides. The current settlement cycle is T+1, which took effect on May 28, 2024, when the SEC shortened the cycle from T+2. After settlement, the fund cancels the redeemed shares and total shares outstanding drop. Net asset value per share for remaining investors is unchanged, and in a fully in-kind exchange no cash moves at all.
Why It Saves Taxes for Remaining Shareholders
The tax advantage of in-kind redemption is the single biggest reason ETFs are usually more tax-efficient than traditional mutual funds. The mechanism lives in Section 852(b)(6) of the Internal Revenue Code, which provides that Section 311(b) does not apply to distributions made by a regulated investment company in redemption of its stock upon demand of a shareholder.
In plain terms: under normal corporate tax rules, when a company distributes appreciated property, it has to recognize gain as if it had sold the property at fair market value. A mutual fund that sells appreciated stock to raise cash for a departing investor triggers that kind of gain, and the fund then passes the gain through to all its shareholders as a taxable capital gains distribution. Investors who never sold a share still get a tax bill.
Section 852(b)(6) shuts that off for in-kind distributions. When the fund hands appreciated securities directly to a redeeming Authorized Participant instead of selling them, the fund recognizes no gain. No gain at the fund means no capital gains distribution to remaining shareholders. Over time, the savings compound, because the fund can strategically push its lowest-cost-basis positions out through in-kind redemptions and keep higher-basis lots that would generate smaller gains if eventually sold.
Heartbeat Trades
The basis-flushing version of this has a name in the industry: heartbeat trades. An Authorized Participant deposits a large basket of securities into the fund, receives freshly created ETF shares, and redeems those same shares a day or two later. On redemption, the fund delivers a custom basket loaded with the appreciated stocks it wanted to offload. Charted, the paired inflows and outflows produce sharp spikes that resemble an EKG reading. The fund’s portfolio comes out with a higher average cost basis and less embedded gain, and the fund itself recognizes no income. Tax scholars have argued the technique stretches the intent of 852(b)(6), but the IRS has not challenged it.
What It Means for the Authorized Participant
The Authorized Participant is not getting a free ride. The exchange of ETF shares for portfolio securities is a taxable event for the participant, who recognizes gain or loss based on the difference between its basis in the surrendered ETF shares and the fair market value of the securities received. The participant’s basis in those received securities is their fair market value at the time of the exchange. The tax doesn’t disappear from the system. It shifts from remaining fund shareholders to the institutional participant, which is typically better positioned to manage it through offsetting positions or inventory accounting.
How ETFs and Mutual Funds Differ
Mutual funds can also redeem in-kind, but they use the option very differently. ETFs redeem in-kind as routine, since nearly every interaction between the fund and its Authorized Participants is a basket exchange. Mutual funds normally pay cash and reserve in-kind delivery for unusually large withdrawals that would otherwise force disruptive sales.
A mutual fund that wants the in-kind option has to file Form N-18F-1 with the SEC under Rule 18f-1. Filing commits the fund to paying cash on all redemption requests up to a per-shareholder limit during any 90-day period: the lesser of $250,000 or 1% of the fund’s net asset value at the start of the period. Anything above that threshold can be paid in securities. The election is essentially permanent. Once filed, it can’t be withdrawn without an SEC order finding that withdrawal is in the public interest and consistent with investor protection. The fund has to disclose the election in either its prospectus or its statement of additional information.
That structural gap is why ETFs distribute far fewer capital gains than comparable mutual funds. A mutual fund facing steady outflows may have to sell appreciated positions month after month, generating taxable gains each time. An ETF facing the same outflows simply hands those positions to Authorized Participants and skips the taxable sale. The efficiency gap shows up most clearly in broad equity index funds, where both structures hold similar portfolios but produce very different after-tax returns.
Cash-in-Lieu Payments and Fees
A perfectly clean in-kind exchange is the ideal, but some holdings can’t be transferred directly. Restricted securities, foreign-listed stocks with settlement complications, and fractional positions often get replaced with a cash-in-lieu payment. The fund calculates the amount from the market value of the untransferable positions, and any trading gains or losses from executing the cash-in-lieu trades are settled between the participant and the fund afterward.
Funds also charge transaction fees on creation and redemption activity to cover operational costs. A fixed fee applies to every order processed through NSCC, and orders placed outside NSCC’s standard system can be charged up to three times that amount. Some funds add a variable fee on large orders, typically 0.00% to 0.50% of order value, though certain fund types allow variable fees as high as 3.00%. The fees exist so that existing shareholders don’t end up subsidizing the transaction costs generated by Authorized Participant activity.