Basics

As with a mutual fund, each share of an ETF represents an undivided interest in the underlying assets. ETFs and mutual funds also both offer professional management, so you don’t have to keep track of every security your fund owns. However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price.

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

How ETFs work

ETFs are traded throughout the day on exchanges at market-determined prices, just like individual securities.

In contrast, mutual fund shares 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 like individual securities, ETFs—like mutual funds—are open-ended investments. This means new shares can be created and existing shares redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of shares.

The ETF creation/redemption process

While any investor can purchase or redeem mutual fund shares directly with the fund company or distributor, only participating dealers can interact directly with the ETF manager to create or redeem ETF shares. Also, while mutual fund investors generally exchange cash for mutual fund shares, the ETF dealer can typically exchange the underlying securities for ETF shares. The ETF shares that dealers create are then traded by investors on an exchange. Learn more about ETF liquidity.