What is an ETF?

What is an ETF in plain terms?

An exchange-traded fund is a pooled investment. The fund collects money, buys a portfolio — shares, bonds, commodities or a mix — and issues its own shares, each representing a slice of that portfolio. What makes it an exchange-traded fund is that those shares are listed on a stock exchange. You buy and sell them through a brokerage account at whatever price the market offers, at any time the exchange is open.

Most ETFs follow an index: a rulebook that defines which assets to hold and in what proportions, such as a list of large companies weighted by their market capitalization. Others are actively managed, with a manager choosing holdings. The SEC notes that two indexes that sound alike can deliver quite different returns, depending on how they choose and weight their holdings — so read the index description, not just the fund's name.

How do ETF shares get created and redeemed?

Ordinary investors never buy shares from the fund directly. Instead, large broker-dealers known as Authorized Participants (APs) deal with the fund in big blocks called creation units. That two-way door is what keeps the price honest.

1. Creation. An AP delivers a basket of the underlying securities (or cash) to the fund and receives a block of new ETF shares.

2. Trading. The AP sells those shares on the exchange, where investors like you buy and sell them with each other.

3. Redemption. An AP returns a block of ETF shares to the fund and receives the underlying basket back.

4. Arbitrage. If ETF shares trade above the value of the holdings, APs can create and sell; if below, they can buy and redeem. The SEC explains that this activity generally keeps the market price close to the fund's net asset value (NAV).

How is an ETF different from a mutual fund or a single stock?

Compared with buying a single company's stock, an ETF spreads your money across many holdings, which reduces the damage any one company can do. It does not remove market risk: if the whole market falls, a broad ETF falls with it. For how such swings are measured, see what is volatility.

What does an ETF cost you?

The expense ratio is the annual fee, taken from the fund's assets, so you never see a bill — it simply trims returns. The SEC notes that ETFs often have lower expense ratios than comparable mutual funds, but costs vary widely. You also pay to trade: any brokerage commission, plus the bid-ask spread, the gap between the price buyers offer and sellers ask.

The 5% figure is purely illustrative; actual returns can be negative. Try your own numbers in the compound interest calculator.

What mistakes do beginners make with ETFs?

• Judging a fund by its name. Read the index methodology and holdings; similar names can hide very different portfolios.
• Holding leveraged or inverse ETFs long term. These reset daily. The SEC's 2023 bulletin gives an example where an index rose 2% over four months while a 2x leveraged ETF on it fell 6%.
• Using market orders in thin trading. In a lightly traded ETF, the spread can be wide; see what is market liquidity.
• Ignoring the expense ratio. It is charged every year, whatever the fund returns.
• Assuming diversification means safety. A broad fund still falls in a broad market decline.