What Is an ETF? How Exchange-Traded Funds Work and How to Invest

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An exchange-traded fund (ETF) is a pooled investment fund that holds a basket of assets, such as stocks, bonds or commodities, and whose shares trade on a stock exchange like an individual stock. “ETF” stands for exchange-traded fund. When you buy one share, you own a slice of the fund, and the fund owns the underlying securities. ETF prices change throughout the trading day as buyers and sellers trade. A traditional mutual fund, by contrast, is bought and sold once a day at a price set after the market closes.

What Is an ETF?

An ETF can be built to track almost anything with a measurable price: a large stock index such as the S&P 500, a narrow industry, a set of government bonds, the price of gold or a currency pair. Some ETFs follow no index at all and instead follow a manager’s decisions. Investors use them to generate income, speculate on price moves, or hedge risk elsewhere in a portfolio.

For example, Vanguard’s Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and holds companies such as Procter & Gamble, Coca-Cola, Walmart, Costco and PepsiCo. A buyer of VDC does not become a direct shareholder of Coca-Cola: they own a share of the fund, and the fund owns the Coca-Cola stock.

How ETFs Work

Legal structure

In the United States, ETFs must be registered with the Securities and Exchange Commission (SEC). Most are open-ended funds governed by the Investment Company Act of 1940, with exemptive relief and later rules allowing their shares to trade on an exchange. Open-ended means the fund does not cap how many shares it can issue: shares are created when demand rises and removed when demand falls.

Some exchange-traded products casually called ETFs are structured differently: many commodity funds are trusts or partnerships, and exchange-traded notes (ETNs) are debt instruments rather than funds. Structure determines what you own and how gains are taxed.

Two prices: market price and NAV

Every ETF has two values at any moment:

• Net asset value (NAV): the value of the fund’s holdings, minus liabilities, divided by the number of shares outstanding. It measures what each share is worth based on the assets inside.
• Market price: the price at which the ETF’s shares actually trade on the exchange, set by supply and demand.

When the market price is above NAV, the ETF trades at a premium; below NAV, at a discount. Mutual funds have no such gap because every trade happens at the end-of-day NAV. For ETFs, creation and redemption usually keep the gap small.

Creation and redemption

The number of ETF shares in circulation is managed by large specialized firms called authorized participants (APs), typically big broker-dealers with agreements with the fund sponsor. Ordinary investors never interact with the fund directly; they trade existing shares with each other on the exchange.

Creation. When demand for an ETF pushes its price above NAV, an AP can buy the underlying securities in the proportions the fund holds them and deliver that basket to the fund. In exchange, the fund issues new ETF shares to the AP in a large block called a creation unit. The AP can then sell those new shares on the exchange.

Redemption. When an ETF trades below NAV, the process runs in reverse. The AP buys ETF shares on the open market, delivers a creation unit’s worth back to the sponsor, and receives the underlying securities in return, which it can sell. The share count shrinks.

Worked example: how arbitrage narrows a premium

Hypothetical example, ignoring trading costs: an ETF closes at a market price of $101 per share while its holdings are worth $100 per share, a $1 premium, or 1% above NAV.

1. An AP buys the underlying stocks at a cost equivalent to $100 per ETF share.
2. It delivers those stocks to the fund and receives newly created ETF shares.
3. It sells the new ETF shares on the exchange for about $101 each, capturing roughly $1 per share.

The new ETF shares push the market price down, and the AP’s buying of the underlying stocks nudges NAV up, until the gap is too small to cover the AP’s costs. At $99 with a $100 NAV, the AP would instead buy ETF shares, redeem them for stocks worth $100 and sell those stocks, again pulling the two prices together.

This mechanism works best when the underlying assets trade actively and are easy to price. When they are not, for example bonds that trade infrequently or foreign stocks whose home market is closed, premiums and discounts can be wider and last longer.

Types of ETFs

ETFs fall into a few broad families. The categories overlap; a fund can be both a bond ETF and actively managed, for instance.

• Passive (index) ETFs. These try to replicate an index, either a broad one such as the S&P 500 or a narrower one covering a sector or theme. Because the manager follows a rulebook rather than picking securities, costs are usually low.
• Actively managed ETFs. Portfolio managers choose what to buy and sell, hoping to outperform or to manage risk differently. They generally charge higher fees than passive ETFs.
• Bond ETFs. These hold government, corporate or municipal bonds and typically pay regular income distributions. Unlike an individual bond, a bond ETF has no maturity date: the fund keeps replacing bonds as they mature, so you cannot count on a fixed amount back on a set day the way you can when holding a single bond to yield to maturity.
• Industry or sector ETFs. These hold companies in one industry, such as energy, technology or biotechnology. The iShares U.S. Technology ETF (IYW), which tracks the Russell 1000 Technology RIC 22.5/45 Capped Index, is one example. They spread risk across companies within an industry but not across industries.
• Commodity ETFs. These give exposure to gold, silver, crude oil and similar goods, either by holding the physical commodity or, more often for energy, futures contracts. Funds that hold futures can perform quite differently from the spot price because they must keep rolling expiring contracts.
• Currency ETFs. These track a single currency or a currency pair and are used to speculate on exchange rates, to diversify, or by importers and exporters to hedge currency risk.
• Bitcoin and Ether ETFs. Bitcoin futures ETFs were approved in 2021, spot Bitcoin ETFs in January 2024, and spot Ether ETFs began trading in July 2024. They give crypto price exposure in an ordinary brokerage account without managing a wallet or private keys.
• Inverse ETFs. These aim to gain when an index or asset falls, using derivatives such as swaps and futures. Some inverse products are structured as ETNs rather than funds.
• Leveraged ETFs. These seek a multiple, such as 2× or 3×, of an index’s daily return, using derivatives and borrowing. If the index rises 1% in a day, a 2× fund aims to rise 2%; if it falls 1%, the fund aims to fall 2%.

Beyond these, there are country and regional ETFs (tracking markets such as Japan, Brazil or emerging markets as a group), dividend-focused ETFs, and funds built around factors such as value, size or low volatility.

How ETFs Are Used

Because one ETF share can represent hundreds or thousands of securities, ETFs serve several distinct purposes:

• Core portfolio building. A few broad ETFs covering domestic stocks, international stocks and bonds can form a complete diversified portfolio.
• Targeted exposure. One trade adds weight to a sector, country or commodity without buying many individual stocks.
• Sector rotation. Some investors move money between industry ETFs as economic conditions change, for instance favoring consumer staples during slowdowns.
• Hedging. Inverse and currency ETFs can offset some risk in other holdings over short periods.
• Cash management and rebalancing. Intraday trading makes ETFs convenient for putting cash to work quickly or rebalancing between asset classes.
• Regular investing. ETFs suit dollar-cost averaging, especially at brokers that offer fractional shares.

How to Invest in ETFs

ETFs are available through online brokers, traditional broker-dealers, investing apps, robo-advisors such as Betterment and Wealthfront, and many retirement accounts, including IRAs and some 401(k) plans. Many platforms charge no commission to trade ETFs, though other costs remain.

A practical sequence:

1. Open and fund an account. Choose a taxable brokerage account or a tax-advantaged retirement account, depending on your goal and time horizon.
2. Decide the ETF’s role. A broad core holding, a bond allocation and a speculative sector bet call for very different funds.
3. Screen and read the holdings. Filter by asset class, expense ratio, trading volume, assets and performance, then check what each fund holds: similarly named ETFs can track different indexes or concentrate in a few companies.
4. Compare total cost. Look at the expense ratio, the typical bid-ask spread and any commission.
5. Place the order. A limit order sets the maximum price you will pay, which protects you if the spread is wide or the market is moving fast. A market order fills at whatever price is available.
6. Monitor tracking. For an index ETF, compare the fund’s return with its index over time.

Expense ratio: a hypothetical cost comparison

The expense ratio is the annual cost of running the fund, expressed as a percentage of assets. It is deducted from the fund’s assets rather than billed separately, which lowers the fund’s return. Index ETFs tend to have low expense ratios because they do not pay for active security selection.

Hypothetical example: on a $10,000 holding, an ETF with a 0.05% expense ratio costs about $5 per year, while one with a 0.75% expense ratio costs about $75 per year. Over decades the gap compounds, because money lost to fees no longer earns returns.

The cost you don’t see on the fact sheet

The bid-ask spread is the difference between the highest price a buyer will pay and the lowest price a seller will accept, and you pay it on each round trip. Heavily traded ETFs often have spreads of a cent or so; small, rarely traded funds can have spreads wide enough to outweigh a low expense ratio for someone who trades often.

Dividends and Taxes

ETF shareholders are entitled to their share of the dividends and interest the fund’s holdings pay, after the fund’s expenses. Funds usually pass this income on as periodic distributions, often quarterly for stock funds and monthly for many bond funds. If a fund is liquidated, shareholders receive their share of the remaining value.

In a taxable U.S. account, you generally owe tax on:

• Distributions, whether you take them in cash or reinvest them. Dividends may be qualified or ordinary depending on the holdings and holding period.
• Capital gains distributions, if the fund itself sells securities at a gain and passes the gain to shareholders.
• Your own capital gain or loss when you sell ETF shares, short-term or long-term depending on how long you held them.

ETFs are often more tax-efficient than mutual funds because of how shares leave the fund. When a mutual fund investor sells, the fund may have to sell securities to raise cash, and any resulting gains are distributed to all remaining shareholders, who owe tax even though they sold nothing. When an ETF investor sells, they usually sell to another investor on the exchange, and the fund is not involved. When redemptions do happen, the fund typically hands the AP securities in kind rather than selling them, so it can remove low-cost-basis holdings without realizing a gain. This does not make ETFs tax-free: distributions are still taxable, and some ETFs, particularly certain bond, commodity and actively traded funds, do distribute capital gains.

Commodity funds structured as partnerships or grantor trusts can be taxed differently from ordinary ETFs, and gains on some precious metals funds may be taxed at collectibles rates in the U.S.

ETFs in the United Kingdom

The U.K. is one of Europe’s largest ETF markets, with London-listed funds covering equities, bonds, commodities, currencies, property and alternative strategies. Key differences from the U.S.:

• ISA eligibility. ETFs can be held in an Individual Savings Account, free of U.K. income tax and capital gains tax, within the annual ISA allowance (£20,000 per tax year at the time of writing).
• No stamp duty. Purchases of ETF shares generally do not incur the stamp duty charged on ordinary U.K. shares.
• UCITS funds instead of U.S.-listed ETFs. Disclosure rules generally keep U.K. retail investors from buying U.S.-listed ETFs, which typically lack the required key information documents. They use European-domiciled funds that comply with UCITS rules instead, many of which track U.S. indexes.
• Ongoing charge. U.K. fund documents usually call the expense ratio the ongoing charges figure (OCF).

ETFs vs. Mutual Funds vs. Stocks

In practice, a mutual fund order placed at 10 a.m. and one placed at 3:55 p.m. get the same price, while an ETF order fills at the market price when it executes.

ETF vs. Index Fund

“Index fund” describes a strategy; “ETF” describes a structure. An index fund is any fund that tracks an index, and the term usually refers to an index mutual fund. Many ETFs are also index funds, so the two overlap rather than compete.

An index ETF and an index mutual fund tracking the same benchmark can hold nearly identical portfolios; the differences come from the wrapper. The ETF trades all day at a market price, tends to be more tax-efficient and has no fund minimum beyond a share’s price. The mutual fund trades once a day at NAV and makes automatic contributions in exact dollar amounts easier, which ETFs match only at brokers offering fractional shares and automatic purchase plans. Costs have converged at many large fund companies, so compare specific funds rather than assuming one wrapper is cheaper.

ETF vs. ETN and Other Exchange-Traded Products

“Exchange-traded product” (ETP) is the umbrella term for securities that trade on an exchange and track an underlying asset or index. ETFs are one kind. Exchange-traded notes (ETNs) are another: an ETN is an unsecured debt obligation of an issuer, usually a bank, that promises to pay the return of an index. An ETN holds no portfolio for you. If the issuer runs into financial trouble, the note can lose value regardless of how the index performs. An ETF’s assets, by contrast, are held separately on behalf of shareholders. ETNs can have no tracking error from portfolio management, but they add issuer credit risk.

Limitations and Risks of ETFs

Owning an ETF does not remove market risk. A broad stock ETF will fall when the stock market falls. Beyond that, several features deserve attention.

Leveraged and inverse ETFs reset daily

Leveraged and inverse ETFs target a multiple of the index’s return for a single day. Over longer periods, compounding makes their results diverge from the simple multiple.

Hypothetical example, ignoring fees: an index starts at 100, rises 10% on day one to 110, then falls 10% on day two to 99. Over two days, the index is down 1%.

A 2× leveraged ETF starting at 100 rises 20% on day one to 120, then falls 20% on day two to 96. It is down 4%, not the 2% that “twice the index” might suggest.

In choppy markets this drag accumulates, which is why these funds are generally designed for short-term trading rather than buy-and-hold investing.

Concentration

Nearly all ETFs are more diversified than a single stock, but not all are meaningfully diversified. A sector ETF puts all its money in one industry, and a fund with half its assets in two or three companies behaves more like those companies than like a market. Even broad market-cap-weighted indexes can become concentrated when a few large companies dominate them. Check the top holdings and their weights, not just the number of holdings.

Liquidity and spreads

Liquidity depends on both the ETF’s own trading volume and how easily its underlying assets trade. Thinly traded funds can fill orders at unfavorable prices, particularly at the open, near the close or during market stress, and funds holding hard-to-trade assets can show larger premiums or discounts to NAV.

Tracking difference

Index ETFs do not match their index exactly. Fees, cash drag, sampling (holding a representative subset rather than every security) and futures roll costs all cause the fund’s return to differ from the benchmark’s.

Fees on specialized funds

Actively managed, leveraged and niche thematic ETFs generally charge more than broad index funds. The higher cost has to be justified by a return above the benchmark, often measured as alpha, or by exposure you cannot get more cheaply.

Closures

ETFs that fail to attract enough assets can be shut down by their sponsors. Shareholders are typically paid out in cash based on NAV, which can trigger a taxable gain at a time you did not choose and leave you to reinvest.

A Brief History of the ETF

The first U.S. ETF was the SPDR S&P 500 ETF Trust (SPY), launched by State Street Global Advisors on January 22, 1993, and still one of the most heavily traded securities in the world. Its precursor was Toronto 35 Index Participation Units, listed on the Toronto Stock Exchange in 1990. ETFs have since expanded from broad stock indexes into bonds, sectors, countries, commodities, currencies, actively managed strategies and, from 2024, spot cryptocurrency funds.

The Bottom Line

ETFs suit investors who want diversified exposure, low costs and intraday trading in brokerage or retirement accounts. Before buying, check each fund's holdings, expense ratio, bid-ask spread and legal structure, since similar names can hide different indexes, concentration or ETN credit risk. Leveraged and inverse funds are built for short-term trading, while broad index ETFs fit long-term core portfolios.