What is an ETF and how does it work?

An exchange-traded fund, or ETF, is a pooled investment that holds a basket of securities, such as stocks or bonds, and whose own shares trade on a stock exchange throughout the day. One ETF share gives you a small slice of everything in the basket. ETFs let an investor buy exposure to a whole index, sector or asset class in a single trade, which is why they have become one of the most common ways to invest.

How an ETF is built

An ETF is run by a fund company, called the sponsor, which publishes the ETF's holdings and its objective. Most ETFs are index funds: they aim to match the results of a chosen index (see what is a stock index) by holding the same securities, or a sample of them, in similar proportions. Others are actively managed, with a manager choosing holdings to try to beat a benchmark.

The first US-listed ETF, which tracks the S&P 500, launched in 1993. ETFs have since expanded to cover bonds, commodities, currencies, specific sectors, themes and more.

How the price stays close to value

Two different prices matter:

• Net asset value (NAV). The value of the ETF's holdings, minus liabilities, divided by the number of ETF shares. It is calculated once a day after the market closes (with intraday estimates also published).
• Market price. The price at which the ETF shares trade on the exchange, moving all day.

These two usually stay very close because of a creation and redemption process. Large financial firms, called authorized participants, can assemble the basket of underlying securities and swap it with the fund for new ETF shares, or hand ETF shares back and receive the underlying securities. If an ETF trades above the value of its holdings, they can profit by creating new shares and selling them, which pushes the price back down. If it trades below, they can buy the cheaper ETF shares and redeem them, which pushes it back up. Market makers also help keep prices in line (see market makers and high-frequency trading).

The mechanism is not perfect, especially in stressed markets or for ETFs holding assets that are hard to trade, where the market price can drift noticeably from NAV.

Example (illustrative numbers)

Imagine an ETF that holds 100 stocks and has 1 million shares outstanding. Its holdings are worth $50 million in total, so:

NAV per share = $50,000,000 / 1,000,000 = $50.00

During the day the ETF might trade at $50.02 on the exchange. If you buy 100 shares at $50.02, you pay $5,002. You then hold a share of the whole 100-stock basket.

The ETF charges an annual expense ratio of 0.10% of assets. On your $5,002 position, that is about $5 a year, which is taken out of the fund's assets gradually, not billed to you separately.

What it costs

• Expense ratio. The annual fee, shown as a percentage of assets. Broad index ETFs are often very cheap, while specialized or actively managed ones usually cost more.
• Bid-ask spread. Each trade costs the gap between the buy price and the sell price. Heavily traded ETFs have narrow spreads, while niche ones can have wide spreads (see bid-ask spread and liquidity).
• Tracking difference. The gap between the ETF's return and its index's return, mostly the fee plus small trading frictions. Tracking error measures how much that gap varies.
• Brokerage costs. Many brokers charge no commission on ETFs, but check your own.

Why people use ETFs

• Diversification in one trade. One position can spread money across many companies (see diversification explained).
• Transparency. Most ETFs publish their holdings daily.
• Intraday trading. You can buy or sell at any moment while the market is open.
• Tax efficiency. Because of the in-kind creation and redemption process, ETFs often distribute fewer capital gains than comparable mutual funds, though this varies by fund and by country.

Types to be careful with

• Narrow or thematic ETFs can be concentrated in a few companies or a fad, so "an ETF" is not automatically diversified.
• Leveraged and inverse ETFs use derivatives to target a multiple or the opposite of an index's daily return. They reset every day, so over longer periods their results can differ sharply from what you might expect, and regulators warn they are generally designed for short holding periods.
• ETFs holding illiquid assets may trade at larger premiums or discounts to NAV.
• Commodity and currency ETFs can behave differently from the spot price they aim to follow.

Common mistakes and limits

• Assuming an ETF cannot lose money. It tracks its holdings, so if the market falls, the ETF falls too.
• Judging by the name only. Two ETFs with similar names can hold different things. Read the objective and holdings.
• Ignoring the spread. Spreads can be wider just after the open and in volatile markets, so a limit order can help (see market, limit and stop orders).
• Chasing last year's best performer. Top-performing ETFs are often narrow bets on whatever has just gone up.

Where to see it on StocksXray

StocksXray focuses on individual S&P 500 stocks rather than funds. It can still help you look under the hood: an S&P 500 ETF owns the same companies that appear on the S&P 500 page, and you can study any of them on its own stock page.

Key takeaways

• An ETF is a basket of securities whose shares trade on an exchange all day.
• Creation and redemption by authorized participants keeps the market price near NAV, though not perfectly.
• Costs include the expense ratio, the bid-ask spread and any tracking difference.
• ETFs vary widely: broad index ETFs differ greatly from leveraged, thematic or illiquid ones.
• An ETF spreads risk across holdings but does not remove market risk.

This article is educational and is not investment advice.