What Is an Exchange-Traded Fund?

An exchange-traded fund is a basket of securities such as stocks that tracks an underlying index. An exchange-traded fund is a marketable security meaning it can be bought and sold since the ETF has a price associated with it. ETFs can contain all types of investments including stocks, commodities, or bonds.

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An Introduction To Exchange-Traded Funds (ETFs)

Exchange-Traded Funds Explained

An ETF is a type of fund that owns underlying assets and divides ownership of those assets into shares. In other words, an ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. For example, the banking ETF would contain all the banks within the industry.

An ETF is called an exchange-traded fund since it's traded on an exchange just like stocks. In other words, investors buy and sell an ETF with its price fluctuating over time. The price of an ETF’s shares will change throughout the day as they are bought and sold. As a result, there can be the potential for a loss to investors if the sale price is lower than the purchase price.

There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor's portfolio. Below are several examples of the types of ETFs.

  • Bond ETFs might include government bonds or Treasuries, corporate bonds, state and local bonds called municipal bonds.
  • Industry ETFs track a particular industry such as technology, banking, or the oil and gas sector.
  • Commodity ETFs invest in commodities including crude oil or gold.
  • Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
  • Inverse ETFs attempt to earn gains from stock declines by shorting stocks, which is selling a stock, expecting a decline in value, and repurchasing it at a lower price. Investors should be aware that many inverse ETFs at ETNs or Exchange Traded Notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. Please check with your broker.

Most ETFs are set up as an open-ended fund and (in the U.S.) are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements.

Key Takeaways

  • An exchange-traded fund is a basket of securities such as stocks that tracks an underlying index.
  • An exchange-traded fund is a marketable security meaning it can be bought and sold since the ETF has a price associated with it.
  • ETFs can contain all types of investments including stocks, commodities, or bonds.
  • ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.

ETF Creation and Redemption

The supply of ETF shares is regulated through a mechanism known as creation and redemption, which involves large specialized investors, called authorized participants (APs). When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index such as the S&P 500 that the ETF tracks and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. The process of an AP selling stocks to the ETF sponsor, in return for shares in the ETF, is called creation.

Conversely, an AP also buys shares of the ETF on the open market, sells them back to the ETF sponsor in exchange individual stock shares that the AP can sell on the open market. As a result the number of ETF shares are reduced through the process called redemption.

The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund's assets.

ETF Creation when Shares Trade at a Premium 

Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per share basis, then the fund's price of $101 is trading at a premium to the fund's net asset value. The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.

An authorized participant has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy the shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.

ETF Redemption when Shares Trade at a Discount

Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks the ETF is holding in the fund is worth $100 per share, then the ETF is trading at a discount to NAV.

To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. In this example, the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares it bought for $99. This process is called redemption, and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased, the price should rise and get closer to its NAV.

Advantages and Disadvantages of ETFs

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks in an ETF individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions since there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

An ETF's expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses since they track an index. For example, if an ETF tracks the S&P 500 index, it might contain all 500 stocks from the S&P making it a passively-managed fund and less time-intensive. However, not all ETFs track an index in a passive manner.

There are also actively-managed ETFs, where portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively-managed ETFs. It's important that investors determine how the fund is managed, whether it's actively or passively managed, the resulting expense ratio, and weigh the costs versus the rate of return to make sure it's worth it.

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share since there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.

While ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value in case the fund is liquidated.

An ETF is more tax efficient than a mutual fund since most buying and selling occurs through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell, or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares they sell it back to the fund, and a tax liability can be created that must be paid by the shareholders of the fund.

Since ETFs have become increasingly popular with investors, many new funds have been created resulting in low trading volumes for some of them. The result can lead to investors not being able to buy and sell shares of a low-volume ETF easily.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability. Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

Learn more about ETFs and the basics of investing in Investopedia Academy's Investing for Beginners course.

How to Buy and Sell ETFs

ETFs can be traded through online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia's list of the best brokers for ETFs. An alternative to standard brokers are Robo-advisors like Betterment and Wealthfront who make use of ETFs in their investment products.

Pros

  • Investors gain access to many stocks across various industries

  • Low expense ratios and fewer broker commissions than buying the stocks individually

  • Help with risk management through diversification over many stocks, securities, and sectors

  • ETFs exist that focus on targeted industries

Cons

  • Some ETFs can be actively managed leading to higher fees than passively-managed funds that track an index

  • Not all ETFs are diversified since funds might focus only several stocks or one industry

  • ETFs with low-trading volumes can lead to investors not being able to buy and sell shares easily

Real World Examples of ETFs

Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.

  • SPDR S&P 500 (SPY): The oldest surviving and most widely known ETF tracks the S&P 500 Index
  • iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index
  • Invesco QQQ (QQQ): Indexes the Nasdaq 100, which typically contains technology stocks
  • SPDR Dow Jones Industrial Average (DIA): Represents the 30 stocks of the Dow Jones Industrial Average
  • Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH)
  • Commodity ETFs: Represent commodity markets including crude oil (USO) and natural gas (UNG)
  • Physically-Backed ETFs: The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund