ETF

An exchange-traded fund (ETF) is an SEC-registered fund holding a portfolio of stocks, bonds or other assets whose shares trade on a stock exchange at market prices throughout the day.

How an ETF works

The SEC's Investor.gov glossary describes an ETF as an exchange-traded investment product that must register with the SEC as an open-end investment company or a unit investment trust. Like mutual funds, ETFs pool money from many investors and invest it in stocks, bonds or other assets, each share representing part ownership of the portfolio and its income. Unlike mutual funds, investors buy and sell ETF shares on national securities exchanges at market prices rather than transacting with the fund at end-of-day net asset value. FINRA's guide to exchange-traded products explains that ETFs generally do not deal directly with retail investors: authorized participants create and redeem shares with the fund in blocks called creation units and trade them on an exchange, which keeps the market price close to the value of the holdings.

Hypothetical example: an ETF's basket is worth $50.00 per share at the close, and the next day its shares trade between $49.90 and $50.15. A limit order at $50.05 fills at that price or better.

Costs and risks

FINRA notes that the vast majority of exchange-traded products are designed to track a market index or benchmark, though some are actively managed, and that ETFs carry expense ratios calculated as a percentage of assets but do not have sales loads or 12b-1 fees. Because ETF shares trade on an exchange, investors also pay a bid-ask spread and may transact at a premium or discount to the underlying value, which FINRA warns can be significant for thinly traded products; it suggests comparing the market price with published estimates such as an intraday indicative value. Tracking error, the gap between fund and benchmark returns, arises from fees, sampling and cash. Investor.gov adds that ETFs can be more tax efficient than mutual funds because in-kind creation and redemption limits realized gains inside the fund.

Hypothetical example: two ETFs tracking the same index charge 0.05% and 0.50% a year. On $10,000 growing 7% before fees, the cheaper fund ends about $3,200 ahead after 20 years. See the fee drag calculator.