An exchange-traded fund (ETF) pools investors’ money into a portfolio of assets, such as stocks or bonds. Each share represents an interest in that portfolio. Most individual investors buy and sell ETF shares through a brokerage account on an exchange, while the fund’s authorized participants handle large-scale creations and redemptions. An ETF’s exchange price, its net asset value, and the costs of trading it are related—but they are not the same.
What is an ETF?
An exchange-traded fund combines money from investors to hold a portfolio of stocks, bonds, or other assets. Owning an ETF share gives you a proportional interest in the fund’s portfolio and the income it generates. The fund may track an index or use an active strategy.
The term ETF does not describe every kind of exchange-traded investment product. The SEC’s investor materials cover ETFs registered as open-end investment companies or unit investment trusts under the Investment Company Act of 1940, and distinguish them from products such as exchange-traded commodity trusts and exchange-traded notes. Their legal structures and risks can differ. SEC: Updated Investor Bulletin: Exchange-Traded Funds
How do ETFs work?
Retail investors trade shares on an exchange
Most individual investors buy and sell ETF shares through a brokerage account on a national securities exchange during trading hours. They generally trade with other market participants at the prevailing market price rather than buying shares directly from, or redeeming them with, the fund.
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Authorized participants create and redeem large blocks
ETF sponsors work with authorized participants, typically large broker-dealers. An authorized participant can deliver a specified basket of securities—and sometimes cash—to the fund in exchange for a large block of ETF shares called a creation unit. It can reverse the process by returning shares to the fund for the basket and any applicable cash. Individual investors ordinarily do not use this process.
The SEC gives 50,000 shares as an example of a creation-unit size; it is an illustration, not a standard size for every ETF. SEC: Updated Investor Bulletin: Exchange-Traded Funds
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Market price and NAV can differ
An ETF’s net asset value (NAV) per share is based on the value of its assets minus its liabilities, divided by its shares outstanding. The fund calculates NAV each business day. Its exchange-traded market price can change throughout the trading day and may be higher than NAV (a premium) or lower (a discount). That means a buyer may pay more than the per-share value of the underlying assets, or a seller may receive less.
Trading and creation-and-redemption activity can help keep market prices near NAV, but they do not guarantee an exact match. A particular ETF may also fail to develop an active trading market. Check the fund’s current price, NAV, and available premium-or-discount information rather than assuming the two values are identical. SEC: Updated Investor Bulletin: Exchange-Traded Funds
ETF vs. mutual fund: what differs?
Both ETFs and mutual funds pool investors’ money and can provide access to diversified portfolios, professional management, and relatively low minimum investments. Neither structure is automatically better; the practical differences include when and how you trade, the costs you pay, and the account in which you invest.
| Feature | ETF | Mutual fund |
|---|---|---|
| How you trade | Retail investors generally buy and sell shares on an exchange through a brokerage account. | Investors generally buy shares from or redeem them with the fund. |
| When the price is set | Trades take place at market prices during exchange hours; the price can differ from NAV. | Orders generally receive the next calculated NAV on a business day. |
| What to check about costs | Fund expenses, any brokerage or intermediary charges, and the bid-ask spread. | Fund expenses and any applicable brokerage or intermediary charges. |
| Holdings information | ETFs may disclose holdings daily; check the fund’s documents for its actual disclosure practices. | Check the fund’s disclosure documents for its holdings information. |
The SEC notes that ETFs have historically often made fewer capital-gains distributions in taxable accounts, but the result depends on the fund and circumstances. In a tax-advantaged account such as a 401(k) or IRA, ETF and mutual-fund ownership do not differ in tax treatment simply because of their structure. SEC: Characteristics of Mutual Funds and Exchange-Traded Funds (ETFs)
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What fees and trading costs should you check?
Fund expenses
Operating expenses are paid from fund assets and reduce returns. Review the prospectus fee table, including the annual operating expense figure, and compare funds with similar objectives, strategies, and share classes where applicable. The expense ratio is useful, but it is not a complete measure of every cost an investor might pay.
Depending on the fund, brokerage commissions or fees from a financial intermediary may apply. Portfolio transaction costs can also affect fund results, even though they are not necessarily shown in the fee table. The SEC’s fee guidance explains that the table does not capture every possible investor cost. SEC: Mutual Fund and ETF Fees and Expenses SEC: How Fees and Expenses Affect Your Investment Portfolio
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Bid-ask spread
For an ETF, the bid is the highest price a buyer is offering and the ask is the lowest price a seller is asking. The difference is the bid-ask spread: an implicit trading cost. The SEC’s 2023 bulletin illustrates this with a $59.50 bid and a $60 ask. Buying 200 shares at the ask and immediately selling them at the bid in that example would cost $100 in spread, before considering any other fees. This is a worked example, not a current estimate of ETF spreads.
More liquid ETFs typically have tighter spreads, but liquidity and spreads vary. Check the spread for the specific fund and trade rather than relying only on the fund’s expense ratio. SEC: Updated Investor Bulletin: Exchange-Traded Funds
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Are ETFs diversified, and can you lose money?
An ETF is not automatically diversified just because it holds a basket or trades on an exchange. Some funds hold many securities; others are concentrated in a narrow sector, a small number of assets, or even a single stock. Review the fund’s objective, strategy, and actual holdings to understand what drives its returns.
ETF shares are not bank deposits and are not insured or guaranteed by the FDIC or another government agency. Holdings can fall in value, distributions can change, and you can lose some or all of the amount invested. Diversification may reduce exposure to an individual issuer, but it cannot eliminate market risk. Past performance does not predict future returns. A fund’s risks depend on its investments and strategy, so read its principal risks and current shareholder report. Investor.gov: Exchange-Traded Funds (ETFs) SEC: Updated Investor Bulletin: Exchange-Traded Funds
Checklist before buying a specific ETF
Use the latest prospectus, the fund’s website, and its SEC filings to assess the fund against your needs. The SEC recommends reviewing a fund’s disclosures and considering its objectives, costs, and risks before investing. Investor.gov: Exchange-Traded Funds (ETFs)
Quick Recap
- Objective and strategy: What is the fund trying to achieve? Is it index-based or actively managed, and what does it hold?
- Diversification and exposure: How many holdings does it have? How concentrated is it, and which markets or sectors are likely to drive its results?
- Costs: What are the annual operating expenses, any brokerage or intermediary charges, and the likely trading costs?
- Spread and liquidity: What are the current bid and ask prices, and how wide is the spread for the trade you are considering?
- Price relative to NAV: Is the ETF trading at a premium or discount? Review current and historical data where available.
- Risks and fit: Can you tolerate the possibility of loss? Does the fund’s objective fit your goals, financial situation, and risk tolerance?
- Disclosure: Read the summary and full prospectus and the most recent shareholder report. Consider a qualified professional for advice tailored to your circumstances.
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