How ETFs Work: A Plain-English Guide to Exchange-Traded Funds

An exchange-traded fund, or ETF, is an investment fund whose shares trade on a stock exchange throughout the day. Like a mutual fund, an ETF pools money from many investors to hold a basket of securities, such as stocks, bonds or commodities-linked instruments, and each share represents a slice of that basket. Unlike a conventional mutual fund, an ETF’s shares are bought and sold on the market at changing prices, just as shares of a company are. Understanding how ETFs work comes down to four things: what the fund holds, how its shares are priced, who creates and redeems those shares, and what it costs to own them.

In brief

• Most ETFs in the United States are registered investment companies regulated under the Investment Company Act of 1940.
• Many ETFs track an index, while others are actively managed.
• ETF shares trade on an exchange at market prices that stay close to the value of the holdings through a creation and redemption process.
• Costs include the fund’s expense ratio plus trading costs such as the bid-ask spread and any broker commission.
• Disclosure documents, including the prospectus and annual reports, are public on SEC EDGAR.

The basic structure

A fund company, called the sponsor or adviser, forms the ETF, files a registration statement with the Securities and Exchange Commission and arranges for the fund to hold a portfolio of securities. A board of directors or trustees oversees the fund, a custodian holds the assets, and an administrator handles accounting. The fund’s investment objective, strategy, risks, fees and holdings policy are set out in its prospectus, which the SEC makes available through EDGAR.

Most ETFs are organized as open-end funds or unit investment trusts and file under the Investment Company Act. Some products that are commonly called ETFs hold commodities or currencies, or use futures, and are structured differently, with different regulatory treatment. Those are often called exchange-traded products. It is worth reading a fund’s prospectus to see which kind you are looking at, because the rules, tax treatment and risks vary.

Index funds and active funds

Most ETFs are passive. They aim to match the return of an index, such as a broad stock market benchmark, a bond index or a sector index, by holding either all the index’s securities or a representative sample. The fund’s return will differ slightly from the index because of fees, trading costs and sampling. The gap is called tracking difference, and its variability over time is tracking error.

A growing number of ETFs are actively managed. A portfolio manager selects securities in an attempt to outperform a benchmark or to meet a goal such as income. Active ETFs generally carry higher expense ratios than index ETFs and depend on the manager’s skill. Some active ETFs publish their holdings daily, while others use structures that disclose less frequently, and the prospectus describes the policy.

How ETF shares are priced

An ETF has a net asset value (NAV), calculated from the market value of everything the fund holds, minus liabilities, divided by the number of shares outstanding. NAV is typically computed once a day after markets close. During the day, ETF shares trade at a market price set by supply and demand. Many funds also publish an intraday indicative value, an estimate of NAV updated through the day.

Market price and NAV can differ. When the market price is above NAV, the ETF trades at a premium, and when below, at a discount. For large, liquid ETFs holding easily traded securities, the gap is usually small. For funds holding less liquid assets, or when markets are under stress, premiums and discounts can widen. The fund company’s website generally publishes historical premium and discount information, and regulators require that disclosure.

Who is involved: authorized participants and market makers

Two groups help keep the market price near NAV. Authorized participants (APs) are large financial firms that have agreements with the fund to create and redeem shares in large blocks. Market makers quote prices at which they will buy and sell ETF shares, which supplies liquidity to ordinary investors. Often the same firm plays both roles. Our companion guide on creation and redemption explains the mechanism in detail.

Ordinary investors do not deal with the fund directly. They buy and sell on the exchange through a brokerage account, and the counterparty is another investor or a market maker.

How you trade an ETF

Because ETFs trade on exchanges, you can use the same order types you use for stocks: market orders, limit orders and stop orders. Prices change throughout the trading day. Investors should consider a few points:

1. Use limit orders where possible, especially for thinly traded ETFs or at times of market volatility, to control the price you pay.
2. Check the bid-ask spread. It is a real cost of trading, and it varies widely across funds.
3. Be careful around the open and close, when quotes can be less reliable.
4. Look at average trading volume and the fund’s size. These are a rough guide to liquidity, though a fund with modest volume can still trade efficiently if its underlying holdings are liquid.

Many brokerages allow fractional shares or commission-free trading of ETFs, but the spread and the fund’s own fees still apply.

Costs

The expense ratio is the annual fee the fund charges, shown as a percentage of assets and deducted from the fund’s assets, so you do not receive a bill. Separate guidance in this series covers fund fees in more detail. Other costs include the bid-ask spread, any brokerage commission, and the costs inside the fund of trading its holdings, which are reflected in performance rather than shown as a line item. The prospectus contains a fee table that states the expense ratio and gives a hypothetical cost example.

Taxes

In a taxable account, you owe tax on dividends and interest the ETF distributes, and on capital gains when you sell shares at a profit. Many ETFs have historically distributed fewer capital gains than mutual funds, partly because of how in-kind creation and redemption works, but this is not guaranteed and depends on the fund. Bond ETFs, commodity ETFs and funds holding foreign securities can be taxed differently. Tax rules change and vary with personal circumstances, so check IRS publications or consult a qualified adviser.

Risks

ETFs are investments, and you can lose money. The main risks include:

• Market risk. If the underlying assets fall, the ETF falls.
• Concentration. Narrow sector, country or thematic funds are less diversified.
• Tracking risk. The fund may not match its index exactly.
• Liquidity risk. Funds holding thinly traded assets can show wide spreads and large premiums or discounts.
• Complexity. Leveraged and inverse ETFs aim for a multiple of a daily return, and over longer periods the results can differ sharply from what an investor expects. The SEC and FINRA have published investor alerts about them.
• Closure. Funds with few assets can be liquidated, which may trigger a taxable event.

A worked example

Suppose a fictional ETF, Broad Market Fund, tracks an index of 500 large stocks. It holds those stocks in roughly the index weights. At the end of a trading day, the fund’s holdings, less liabilities, are worth $1 billion, and 20 million shares are outstanding. The NAV is $50 per share.

During the day, demand surges and the market price rises to $50.20 for a few minutes. Market makers and APs see that the shares trade at a premium to the value of the underlying stocks. An AP can deliver the basket of stocks to the fund in exchange for newly created ETF shares, then sell those shares in the market. That increase in supply pushes the price back toward NAV. If the price had dropped below NAV, the process would run in reverse. The fund’s expense ratio, deducted gradually from the assets, would cause its return to trail the index by a small amount over the year.

Common misconceptions

• ETFs are not all stock funds. Many hold bonds, and some hold commodities or use derivatives.
• An ETF is not automatically low cost or low risk. Expense ratios and risks vary widely.
• Daily liquidity of the shares does not mean the underlying holdings are equally liquid.
• Index ETFs do not eliminate market risk. They deliver the market’s return, up or down, less costs.

FAQ

What is the difference between an ETF and an index fund?

An index fund is any fund that tracks an index. It can be an ETF or a mutual fund. The difference lies in how shares are bought and sold.

Can I buy an ETF directly from the fund company?

Usually not. Individual investors buy ETF shares on an exchange through a broker. Only authorized participants deal with the fund directly.

Do ETFs pay dividends?

If the underlying holdings pay dividends or interest, the fund generally passes the income to shareholders after expenses, on a schedule described in its prospectus.

Where can I find an ETF’s holdings and fees?

In the prospectus and the fund sponsor’s website. Registration statements and reports are on SEC EDGAR.

Are ETFs safe?

No investment is free of risk. The SEC’s Investor.gov explains the characteristics and risks of ETFs, and the right choice depends on your goals and risk tolerance.