What Is an ETF (Exchange-Traded Fund) and How Does It Work?

By
Harris
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Key Points

  • An exchange-traded fund (ETF) pools money from many investors into a portfolio of stocks, bonds or other assets, and each share is a slice of that portfolio.
  • Unlike mutual fund shares, ETF shares trade on stock exchanges throughout the day at market prices, which can sit above or below the fund’s net asset value (NAV).
  • Large broker-dealers called authorized participants create and redeem ETF shares in big blocks, a process that helps keep the market price close to NAV.
  • ETFs can track an index or be actively managed; leveraged, inverse and single-stock ETFs are specialized products, and ETNs are debt, not funds.
  • Costs include the fund’s expense ratio, any brokerage commission and the bid-ask spread, and ETFs are not insured by the FDIC.

An ETF, or exchange-traded fund, is an investment fund that holds a basket of assets, such as stocks or bonds, and trades on a stock exchange like a single stock. Buying one share gives you a small ownership stake in everything the fund holds. That combination of a fund’s diversification with a stock’s all-day trading is what sets ETFs apart.

Here is how ETFs work, how they differ from mutual funds, what they cost and what can go wrong, based on guidance from the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). This is general educational information, not personal financial advice.

What is an ETF?

According to the SEC’s Investor.gov, an ETF is an exchange-traded investment product that must register with the SEC as an open-end investment company or a unit investment trust. ETFs pool money from many investors and invest it in stocks, bonds, short-term money-market instruments, other securities or assets, or a mix of these.

The combined holdings are called the fund’s portfolio, which is usually managed by an SEC-registered investment adviser. Each ETF share represents part ownership of that portfolio and of the income it generates.

Investor.gov says people buy ETFs for professional management, diversification, low minimum investments and the ability to trade whenever the market is open. FINRA calls ETFs the most common type of exchange-traded product, or ETP, a broader label for exchange-listed securities that track a benchmark, an index such as the S&P 500, or an active strategy.

How does an ETF work?

Retail investors do not buy shares from the fund itself. They trade existing shares on an exchange, usually through a brokerage account.

Authorized participants and creation units

New shares come from a wholesale channel. The SEC explains that fund sponsors contract with authorized participants, typically large broker-dealers. Usually only these firms buy or redeem shares directly with the ETF, and only in large blocks called creation units, such as 50,000 shares in the SEC’s example.

To create shares, an authorized participant delivers a basket of securities and cash that generally mirrors the portfolio and receives ETF shares it can sell on an exchange. Redemption runs in reverse: it hands a block of shares back and receives securities or cash.

Market price vs. net asset value

Every ETF must calculate its net asset value, or NAV, per share each business day: assets minus liabilities, divided by shares. On the exchange, though, the price moves all day with demand and the prices of the fund’s holdings. Above NAV, shares trade at a premium; below it, at a discount. So you can pay more, or receive less, than the underlying assets are worth.

What keeps the price close to NAV?

Arbitrage. Authorized participants can trade with the fund at NAV and on the exchange at market prices, so they can profit from any gap. The SEC says the expected result is that the market price moves back in line with NAV. FINRA notes that a disruption in creations or redemptions can let the price drift significantly.

ETF vs. mutual fund: what is the difference?

Both are SEC-registered investment companies that pool investor money, offer professional management and calculate NAV every business day. The SEC stresses that their different structures create different benefits and risks.

Question ETF Mutual fund
Where you buy and sell On a stock exchange, through a brokerage account From the fund, or via a broker or adviser
Price you get Market price during the day, which may differ from NAV Next calculated NAV, plus or minus fees
Holdings disclosure Most post holdings daily Periodically
Typical extra trading costs Possible commission, plus the bid-ask spread Possible purchase or redemption fees
Capital gains distributions Typically fewer, thanks to in-kind exchanges Typically more than a similar ETF

What types of ETFs are there?

The first split is strategy. An index-based ETF tries to match an underlying index, while an actively managed ETF has an adviser picking investments to meet a stated objective. Investor.gov says passive strategies usually mean less trading and lower fees, and FINRA says active products may carry higher expense ratios. To see what an index fund is following, our explainer on how U.S. stock market indexes are calculated walks through the major benchmarks.

By asset, most ETFs focus on stocks and bonds:

  • Equity ETFs hold stocks, often from one sector, company size or country.
  • Bond ETFs hold debt securities, typically pay regular income, and may be less volatile than some other ETFs.
  • Money market ETFs invest in liquid, short-term debt, cash and cash equivalents.

Leveraged, inverse and single-stock ETFs

FINRA explains that leveraged and inverse ETPs aim to deliver a multiple, such as two or three times, or the opposite of a benchmark’s return, usually over one day or one month, and generally are not designed to be held longer than that. Many single-stock ETFs offer similar geared exposure to one company.

ETFs vs. ETNs and other exchange-traded products

An exchange-traded note, or ETN, trades like an ETF but holds no assets. FINRA says ETNs are unsecured debt issued by a bank or other financial institution, so their value depends on the issuer’s strength. Other ETPs that hold gold, currencies, crypto assets or futures may not be registered under the Investment Company Act of 1940, and FINRA warns that some are still called ETFs or funds while offering different investor protections.

How do investors make money from an ETF?

Investor.gov describes three ways an ETF can produce a return:

  • Dividend payments. When the portfolio earns dividends or interest, the fund pays nearly all of that income, minus expenses, to shareholders.
  • Capital gains distributions. When the fund sells holdings that have risen in price, it distributes those gains, net of losses, to investors.
  • A higher market price. If the portfolio’s value rises after expenses, NAV rises, and the share price may rise with it.

Investor.gov notes that reinvesting ETF payouts can be more complicated than with a mutual fund and may involve extra commissions.

What does an ETF cost?

Every ETF charges ongoing fees, deducted from fund assets, so you pay them indirectly. FINRA says ETFs have expense ratios, a percentage of assets invested, but no loads or 12b-1 fees. The SEC says ETFs have tended to cost less to operate than similar mutual funds. Small fee differences can add up over time, and FINRA’s free Fund Analyzer compares specific funds.

Trading adds two costs. One is any brokerage commission; FINRA cautions that commission-free trading should not be the only reason to pick a product. The other is the bid-ask spread, the gap between the highest price a buyer will pay and the lowest a seller will accept. In the SEC’s example, an ETF is quoted at $59.50 bid and $60.00 ask. Buying 200 shares at $60 and selling them immediately at $59.50 loses $100. More heavily traded ETFs typically have tighter spreads.

How are ETFs taxed?

Many ETFs create and redeem shares through in-kind exchanges rather than cash, so they typically make fewer capital gains distributions than mutual funds, and shareholders may owe less tax on a similar investment. That is not tax-free. FINRA notes you still owe tax on realized gains when you sell, must report dividends and interest, and that leveraged, inverse, commodity and currency ETPs can create their own tax liabilities. ETFs can sit in taxable brokerage accounts or tax-advantaged retirement accounts. Our guide to choosing between a 401(k) and an IRA explains how those account types differ. For specific tax questions, a tax professional is the right resource.

What are the main risks of ETFs?

ETFs are not guaranteed or insured by the FDIC or any other government agency, and you can lose some or all of the money you invest. The SEC and FINRA highlight several risks to understand:

  • Market risk. An ETF rises and falls with its holdings, and a stock fund can drop sharply in the short term.
  • Premiums and discounts. The price can sometimes deviate significantly from NAV.
  • Tracking error. An index fund’s return can drift from its index.
  • Liquidity risk. Thinly traded ETFs can have wide spreads, liquidity can dry up after a delisting, and some ETPs can be liquidated, at times with little warning.
  • Overlap. Owning several ETFs with similar holdings can reduce your overall diversification.

Past performance does not predict future returns, Investor.gov reminds investors, and the higher the potential return, generally the higher the risk of loss.

How can you research an ETF before buying?

The SEC’s investor bulletin on exchange-traded funds recommends reading the summary and full prospectus, which cover the fund’s objective, strategies, risks and costs and are available on the SEC’s EDGAR database and fund websites. Fund sites also show NAV, premiums or discounts, holdings and the median bid-ask spread. Questions to ask:

  • What is the fund’s objective, and what assets does it hold?
  • How does that fit your goals and risk tolerance?
  • Who is the investment adviser?
  • What fees does it charge, and will you pay a commission to trade?

For specialized products, FINRA’s guide to exchange-traded funds and products covers ETNs, geared funds and commodity, currency and crypto ETPs in more depth. To see how the stock, gold and oil markets that many ETFs track are moving, follow the Markets Live center.

The bottom line

An ETF is a pooled fund that trades like a stock. Authorized participants and arbitrage generally keep its price near the value of its holdings, and ETFs have tended to cost less and distribute fewer taxable gains than similar mutual funds. Still, they carry market risk and trading costs, and specialized leveraged or inverse products carry risks that are easy to miss. Before buying any fund, read its prospectus and understand what it owns and charges.

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