Like a traditional mutual fund, an exchange-traded fund (ETF) offers the opportunity to invest in a portfolio of securities, such as stocks or bonds.
As with a mutual fund, each unit of an ETF represents an undivided interest in the underlying assets. ETFs and mutual funds also offer professional management, so you don't have to keep track of every security the fund owns. However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price, providing additional flexibility and efficiency.
Most ETFs use an indexing approach. They're built so that their value can be expected to move in line with the indexes they seek to track. For example, a 2% rise or fall in an index should result in approximately a 2% rise or fall for an ETF that tracks that index (before fees and expenses).
ETFs combine the features of mutual funds with those of individual stocks:
Mutual fund characteristics
- Diversified
- Professionally managed
Individual stock characteristics
- Continuously priced
- Liquid
ETFs are not derivatives
A derivative is a financial contract whose value is based on, or derived from, a traditional security. ETFs are not derivatives because, like most mutual funds, they typically invest directly in the physical securities of their target benchmarks. Thus, an ETF's value is based on the net asset value of its underlying pool of securities. Even so, it's important to note that some ETFs are synthetic, which means they invest in derivatives as part of their stated investment strategy. Additionally, even some ETFs that invest primarily in physical securities may invest a portion of assets in derivatives in order to hedge exposure to foreign currency fluctuations.
How ETFs work
ETFs are traded throughout the day on an exchange at market-determined prices, just like individual securities.
In contrast, mutual fund units are bought and sold directly through the fund company at the fund's net asset value (NAV) at the end of each trading day.
Although they trade similarly to individual securities, ETFs—like mutual funds—are open-ended, meaning that new units can be created and existing units redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of units or shares.
The process that makes mutual funds open-ended is relatively simple. When an investor buys into a fund, the fund manager creates new units; when an investor sells out of a fund, the manager removes units from circulation. This is what ensures that a mutual fund's price is based on the net asset value (NAV) of its underlying portfolio—not on changing demand for the fund itself.
Since an ETF trades on an exchange, the process that makes ETFs open-ended differs from that of mutual funds. ETFs rely on a unique creation/redemption process to regulate the supply of units in circulation.
The ETF creation/redemption process
While any investor can purchase or redeem mutual fund units directly with the fund company, only an authorized dealer can interact directly with the ETF manager to create or redeem ETF units. Also, while mutual fund investors generally exchange cash for mutual fund units, the ETF dealer can typically exchange the underlying securities for ETF units. The ETF units that dealers create are then traded by investors on an exchange. This process not only creates liquidity for the ETF, but also helps keep the ETF's market price in line with the NAV of its underlying portfolio.
