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 in a mutual fund, each share in an ETF represents an entire stake 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 has. However, ETFs are different in that they can be traded on an exchange during the day at a price determined by the market.
Most ETFs use an indexing approach. They are constructed in a way that their value is expected to move in line with the indices they are trying to track. For example, a 2% increase or decrease in an index should produce a 2% increase or decrease in an ETF that tracks that index (before charges and expenses).
How ETFs Work
ETFs are traded on exchanges during the day at market-determined prices, just like individual securities.
In contrast, mutual fund shares are bought and sold directly through the fund company based on the fund’s net asset value (NAV) at the end of each trading day.
Although they are traded as individual securities, ETFs are open investments just like mutual funds. This means that new shares can be created daily and existing shares can be redeemed based on investor demand. On the other hand, closed funds and individual securities usually issue a fixed number of shares.
The ETF creation / redemption process
Although any investor can directly buy or redeem the mutual fund shares with the company or fund distributor, only participating distributors can interact directly with the ETF manager to create or redeem the ETF shares. Additionally, although mutual fund investors typically exchange cash for mutual fund shares, the ETF distributor can usually exchange the underlying securities for ETF shares. The ETF shares that dealers create are then traded on an exchange by investors. Get more information .