What’s an exchange traded fund?

Exchange traded funds (ETFs) share some characteristics with individual securities and others with mutual funds. With ETFs, you buy and sell shares in an entire portfolio of securities — sometimes called a basket of securities — the same way you buy and sell shares of a single stock. And like stocks, ETF shares are traded through a brokerage account.

The benefit of this fund structure is that you can buy and sell during the trading day, unlike a mutual fund, which can only be purchased or sold at the close of business.

But similar to a mutual fund, you own shares of the ETF rather than shares of the underlying investments. And both types of funds have a net asset value (NAV) that reflects what a single share is worth at a particular point in time.

Each ETF tracks a particular index or sector and, like an index fund, seeks to replicate its performance by owning all of the securities listed on the index. ETFs, like the indexes they track, may include several dozen, several hundred, or even several thousand securities. As with index funds, ETFs lag the underlying index by a small margin, known as the tracking error, on account of fund expenses and fees. The tracking error may also be influenced by the fact that index values are determined as of 4pm when the U.S. stock markets close, but ETF trading continues after the closing.

Creating an ETF

After receiving permission to establish an ETF from the Securities and Exchange Commission (SEC), the fund sponsor — usually a major money management firm — partners with a large broker, market maker, or other institutional investor, called the authorized participant. The authorized participant accumulates a basket of securities that matches the composition of the underlying index.

The securities are sent to a bank for safekeeping, and the fund sponsor sends the ETF shares to the authorized participant, who offers them for sale. After the initial sale, investors can buy and sell shares in the secondary market.

ETFs usually have a lower expense ratio than traditional actively managed mutual funds. The average ETF expense ratio is less than 0.30% versus over 1.00% for these mutual funds.

The cost of trading an ETF is the commission charged, similar to the commission charged when trading a share of stock. When compared to the cost of trading traditional load mutual funds this cost can also be lower.

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