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An exchange-traded fund (ETF) is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges, and ETF shares trade throughout the day just like an ordinary stock.

Some well-known example is the $SPDR S&P 500 ETF(SPY.US)$, which tracks the S&P 500 Index. ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An exchange-traded fund is marketable security, meaning it has an associated price that allows it to be easily bought and sold.

• An exchange traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock.

• ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.

• ETFs can contain all types of investments including stocks, commodities, or bonds; some offer U.S. only holdings, while others are international.

• ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.

Types of ETFs

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.

• Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ

• Bond ETFs: Designed to provide exposure to virtually every type of bond available; U.S. Treasury, corporate, municipal, international, high-yield and several more

• Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology

• Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn

• Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth

• Foreign market ETFs: Designed to track non-U.S. markets, such as Japan's Nikkei Index or Hong Kong's Hang Seng index

• Inverse ETFs: Designed to profit from a decline in the underlying market or index

• Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index

• Exchange-traded notes: In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes

• Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing

How ETFs work

An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.

Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.

Why and why not

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio 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.

Pros

• Access to many stocks across various industries

• Low expense ratios and fewer broker commissions.

• Risk management through diversification

• ETFs exist that focus on targeted industries

Cons

• Actively-managed ETFs have higher fees

• Single industry focus ETFs limit diversification

• Lack of liquidity hinders transactions

How to Trade ETFs

ETFs trade through online brokers and traditional broker-dealers. 

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.

Dividends and ETFs

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 if the fund is liquidated.

ETFs and Taxes

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 a mutual fund, each time an investor sells their shares they sell it back to the fund and incur a tax liability can be created that must be paid by the shareholders of the fund.

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).

• Creation: When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—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.

• 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 (NAV). 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 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.

• Redemption: Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for 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.

• 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.