How does an ETF work?
A fund company, the issuer, pools money from many investors and buys the holdings its rules call for, most often the stocks of an index. The fund is split into shares listed on an exchange such as NYSE Arca or Nasdaq, which you trade through a brokerage account during market hours with the same order types as stocks.
You own shares of the fund, not the stocks inside it. They rise and fall with the whole basket, and the holdings’ dividends usually reach you as fund distributions, after costs.
Hypothetical: an ETF holds 100 stocks worth $1 billion in total and has 20 million shares. Each share represents about $50 of the basket: the fund’s net asset value (NAV) per share. The SPY day trading guide covers the best-known ETF of all.
- Exchange-traded fund (ETF)
- A fund that holds a basket of assets and trades on an exchange under one ticker, at a market price that changes through the day.
- Net asset value (NAV)
- The value of everything the fund holds, minus its liabilities, divided by its shares. The official NAV is calculated once a day after the close.
Types of ETFs: index, sector and thematic
Index ETFs follow a broad index and hold all or most of its stocks, usually weighted by market cap. SPY and VOO track the S&P 500, and QQQ tracks the Nasdaq-100. One share spreads your money across hundreds of companies; see stock market indexes and index fund investing.
Sector ETFs hold one industry, such as technology (XLK) or financials (XLF); see stock market sectors. Thematic ETFs go narrower still, built around one idea such as robotics (BOTZ) or clean energy (ICLN), often with fewer holdings. The narrower the basket, the harder one industry’s bad year can hit you.
There are also ETFs that hold bonds, gold or other commodities, and ETFs that screen their holdings by Islamic criteria; see halal stock investing.
Why does an ETF trade close to its NAV?
An ETF has two prices: its NAV, the value of the holdings per share, and its market price, set by buyers and sellers on the exchange. In a liquid ETF the two stay very close, thanks to a process called creation and redemption.
Large trading firms called authorized participants (APs) can give the issuer a basket of the underlying stocks for new ETF shares (creation), or hand back ETF shares for the stocks (redemption). At a premium, when the ETF trades above its NAV, they create shares and sell them, pushing the price down. At a discount they buy shares and redeem them, pushing it up. That arbitrage keeps the gap small.
It works less well when the holdings are hard to trade, such as some bonds or foreign stocks whose market is closed, or in a very fast market. The gap can widen then, so use limit orders with ETFs.
ETF vs mutual fund: what is the difference?
Both pool investors’ money into a managed basket, and many index mutual funds track the same indexes as ETFs. The differences are in how you buy, sell and pay. Which funds you can buy, and how they are taxed, depends on your country and broker; see how to buy US stocks.
- Trading: an ETF trades all day at a market price; a mutual fund is bought or sold once a day, at that day’s NAV after the close.
- Access: an ETF is bought through any brokerage account, from one share; a mutual fund through the fund company or a platform that sells it, sometimes with a minimum investment.
- Costs: index ETFs often have low expense ratios, but you pay the bid-ask spread when you trade; some mutual funds add sales charges.
Leveraged and inverse ETFs: why the daily reset causes decay
A leveraged ETF aims for a multiple, such as 2x or 3x, of an index’s return for a single day; an inverse ETF aims for the opposite of the day’s move, for example −1x. They reset daily, so over longer periods their return can differ widely from the multiple you expect, and in a choppy market the gap usually works against you.
Hypothetical two days, before fees: an index starts at 100, rises 10% to 110, then falls 10% to 99, a 1% loss. A 2x fund starting at $100 rises 20% to $120, then falls 20% to $96: a 4% loss, not 2%. An inverse (−1x) fund falls 10% to $90, then rises 10% to $99, so it also lost 1% while the index fell 1%.
FINRA, the US brokerage regulator, has warned that these funds are typically unsuitable for retail investors who plan to hold them for longer than one trading session. In a sharp move they can lose most of their value quickly. The QQQ day trading guide explains why TQQQ behaves so differently from QQQ.
How to read an ETF page: expense ratio, holdings and spread
The expense ratio is the yearly fee a fund takes from its assets, as a percentage. You never get a bill: it is deducted gradually and shows up as slightly lower returns. Hypothetical: $10,000 in an ETF with a 0.10% expense ratio costs about $10 a year; at 0.75%, about $75. Broad index ETFs usually charge less than sector, thematic or leveraged ones.
On the issuer’s page or your broker’s quote screen, check these before you buy:
- What it tracks, and the expense ratio: compare funds on the same index by cost first.
- Top holdings and their weights: a few giant positions can dominate a fund.
- Assets under management (AUM) and volume: bigger, busier funds usually have tighter spreads.
- Premium or discount to NAV, and the bid-ask spread you will pay.
- Distributions: how often dividends are paid; see how dividends work.