To create an
ETF
and offer it to investors, a sponsor, usually a major money management firm, first seeks approval from the
Securities and Exchange Commission (SEC).
The sponsor then works with a large broker or specialist, called an authorized participant, who accumulates a basket of specific securities that are to be included in the particular fund — stocks for a stock ETF or bonds for a bond ETF. The basket is equal in value to a fixed number of ETF shares, known as a creation unit, and typically totals 50,000 shares.
The securities are sent to a custodian, typically a bank, for safekeeping. The custodian, in turn, sends the ETF shares to the authorized participant, who offers them for sale. After the initial sale, the shares trade in the secondary market, and investors buy and sell shares through a
brokerage firm,
just as they do stocks. In fact, three ETFs — the SPDR, the iShares Russell 2000, and the NASDAQ 100, which is made up of the 100 largest nonfinancial companies listed on the NASDAQ Stock Market — are among the most actively traded issues in U.S. markets.
ETFs also resemble mutual funds, particularly index funds, in certain ways. Each fund has a
net asset value (NAV)
that reflects what a single share is worth at a particular point in time. The performance of each fund is linked to the performance of its underlying investments. In the case of ETFs and index funds, though, the results aren't identical to the performance of the indexes they track. The difference between the index results and the fund results is determined by the fees you pay to own the fund, whether or not the fund actually owns all the securities in the index or just a representative sample of those securities, and when any dividends or interest the securities pay is reinvested. With stock ETFs, this price variation, known as the tracking error, may also be influenced by the fact that index values are determined as of 4 pm when the stock market closes, but ETFs trading continues.
