How an ETF works
Like a mutual fund, an ETF pools investors’ money in a portfolio run by an SEC-registered adviser, and each share is a proportionate slice of that portfolio. The difference is how shares come into existence. You never buy from the fund itself. Large broker-dealers called authorized participants create new ETF shares in big blocks, called creation units, such as 50,000 shares, usually by handing the fund a basket of the securities it holds. They can reverse the trade too, returning shares in exchange for a basket. Everyone else buys and sells ETF shares on a stock exchange at market prices, throughout the trading day, through a brokerage account.
The fund still calculates its net asset value (NAV) every business day. When the market price drifts above NAV, authorized participants can profit by creating shares and selling them; when it drifts below, by buying shares and redeeming them. That arbitrage usually keeps an ETF’s price close to its NAV, but the price can still trade at a premium or a discount, sometimes a large one. Many ETFs follow an index, others are actively managed, and most post their holdings on their websites every day.
What an ETF really costs
An ETF charges an annual expense ratio, paid out of fund assets, and it typically does not charge the sales loads or 12b-1 distribution fees that some mutual funds do. The SEC says ETFs have tended to be cheaper to run than mutual funds that invest the same way. But the prospectus fee table leaves out the costs of trading on an exchange, so check the fund’s website: ETFs that rely on the SEC’s 2019 ETF rule must post their bid-ask spread data and their history of premiums and discounts there. The costs the fee table leaves out are:
- Commissions: some brokers charge a flat fee per trade, which is a bigger percentage of a small trade.
- The bid-ask spread: you buy at the higher ask price and sell at the lower bid. Heavily traded ETFs usually have tighter spreads, and a limit order caps the price you pay.
- Premiums and discounts: you may pay more than NAV when buying, or receive less when selling.
Why ETFs are usually tax-efficient
When a mutual fund needs cash to pay departing shareholders, it may sell securities at a gain, and it must pass net realized gains on to the shareholders who stay as a taxable distribution. An ETF usually meets redemptions differently, by handing authorized participants a basket of securities instead of cash. Under section 852(b)(6) of the tax code, a regulated investment company that distributes appreciated securities to meet a shareholder’s redemption request does not recognize the gain. As a result, the SEC notes, ETFs typically make fewer capital gains distributions than mutual funds.
Tax-efficient does not mean tax-free. ETF dividends and interest are still taxed each year in a taxable account, some ETFs still distribute gains, and you owe tax on your own gain when you sell. In an IRA or 401(k) the advantage disappears: the SEC notes there is no tax difference between an ETF and a mutual fund held in a tax-advantaged account. ETF tax efficiency therefore matters mainly for the taxable side of an asset location plan, where it reduces tax drag.
Types of ETFs, and products that only look like one
Most ETFs are plain registered funds that hold stocks, Bonds or both: broad-market index funds, sector and international funds, bond funds and actively managed funds. Their risk is the risk of what they own.
Other products under the ETF label behave very differently. Leveraged ETFs aim for a multiple, such as 2×, of an index’s daily return, and inverse ETFs aim for the opposite of it, using swaps, futures and other derivatives. Because they reset every day, their results over weeks or months can differ sharply from the multiple you might expect. In one SEC example, an index gained 2% over four months while a fund seeking twice its daily return fell 6%. Single-stock ETFs apply leveraged or inverse exposure to one company, so they offer no diversification at all.
Some exchange-traded products are not funds. Exchange-traded notes are unsecured debt of a financial institution, and exchange-traded commodity trusts are not registered under the Investment Company Act of 1940, so they lack the protections registered funds provide, even when “ETF” appears in the name. The SEC suggests checking the investment strategy section of the prospectus rather than trusting the name.
ETF or mutual fund: the practical differences
Both structures are registered funds, both can be index or actively managed, and both can be broadly diversified at low cost, so the right choice often comes down to how you invest. Someone who buys a fixed dollar amount every month, as in dollar-cost averaging, may value a mutual fund’s automatic reinvestment and fractional shares; someone investing a lump sum in a taxable account may value an ETF’s tax efficiency. The SEC highlights these differences:
- Price: ETFs trade all day at market prices; mutual fund orders are filled at the next NAV, calculated after the close.
- Account: you need a brokerage account for ETFs; mutual fund shares can be held directly with the fund.
- Reinvestment: mutual funds typically reinvest distributions automatically; ETF investors may need separate trades, and ETFs themselves typically do not issue fractional shares.
- Fees: ETFs rarely charge loads or 12b-1 fees but come with spreads and possibly commissions.
- Taxes: in a taxable account, ETFs typically distribute fewer capital gains.
Illustrative numbers
Trading costs on a $10,000 ETF purchase
- Market price
- The price at which ETF shares trade on the exchange
- NAV per share
- The value of the fund’s assets minus its liabilities, divided by shares outstanding
A positive result is a premium and a negative one a discount; compare using the same moment, usually the market close.
QuoteBid $49.95, ask $50.05
Buy 200 shares at the ask$10,010
Value if sold right away at the bid$9,990
Round-trip spread cost$20, or 0.2%
Expense ratio of 0.05% on $10,000About $5 a year
Selling right away would lose $20 to the spread, about four years of this fund’s expense ratio. A buy-and-hold investor pays the spread once, but frequent trading, thinly traded ETFs and stressed markets can make spreads and premiums the biggest cost of owning an ETF.
At a glance
Exchange-traded products compared
| Product | Legal structure | What it aims to do | Key risk to know |
|---|---|---|---|
| Traditional ETF | Open-end fund or unit investment trust registered under the Investment Company Act of 1940 | Track an index or pursue an active strategy | The market risk of its holdings; premiums or discounts to NAV |
| Leveraged or inverse ETF | Registered ETF that uses swaps, futures and other derivatives | A multiple, or the opposite, of an index’s daily return | Results over weeks or months can differ sharply from the daily target |
| Single-stock ETF | Registered ETF focused on one company | A multiple, or the inverse, of one stock’s daily return | No diversification and amplified swings |
| Exchange-traded note (ETN) | Unsecured debt of a financial institution | Pay a return linked to an index or benchmark | Issuer credit risk; the whole investment can be lost |
| Exchange-traded commodity trust | Not registered as an investment company under the 1940 Act | Hold commodities, currencies or related derivatives | Lacks registered-fund protections even if called an ETF |
Put it in your plan
ETF in MoneyWhatIf
In MoneyWhatIf, an ETF’s economics are entered on the account that holds it. Give the account its own growth and dividend rates or let it follow the plan’s shared assumptions, and enter the fund’s expense ratio as the account’s yearly fee, which reduces its modeled balance. In a taxable brokerage account, dividends are taxed as received using the qualified share you select, reinvested dividends raise the remaining cost basis, and Tax Planning can test harvesting gains by selling and immediately repurchasing appreciated investments to raise basis.
Common questions
ETF FAQs
What is the difference between an ETF and an index fund?
They answer different questions. “Index fund” describes a strategy: matching a market index instead of trying to beat it. “ETF” describes a structure: a fund whose shares trade on an exchange. An index fund can be a mutual fund or an ETF, and an ETF can track an index or be actively managed. Because many ETFs track indexes, the two terms often get blurred.
Do ETFs pay dividends?
Yes. An ETF passes through the dividends and interest its holdings pay, minus expenses, and it may also distribute capital gains. In a taxable account those payments are taxable in the year you receive them, and dividends from stock ETFs can count as qualified dividends if holding-period rules are met. Reinvesting ETF payouts can take separate trades, so ask your broker whether it reinvests them automatically.
Are ETFs safer than individual stocks?
A broad ETF spreads your money across many companies, so one company’s collapse hurts far less than it would if you owned that stock alone. It does not remove market risk: a stock ETF falls with its market, and ETFs are not FDIC-insured. Narrow, leveraged, inverse and single-stock ETFs can be riskier than the Stocks they are built on, not safer.
How do you buy an ETF?
You need a brokerage account, which can be a taxable account or an IRA held at a broker. Look up the fund’s ticker symbol, choose the number of shares and pick an order type: a market order fills right away at the best available price, while a limit order sets the most you will pay. Check the bid-ask spread before you trade, and note that ETFs typically don’t issue fractional shares.
When were ETFs created?
The SEC approved the first ETF in 1992, and the first US ETF, the SPDR S&P 500 ETF Trust, which tracks the S&P 500, began operating in January 1993. For years each ETF needed its own exemptive order from the SEC. In September 2019 the SEC adopted Rule 6c-11, a single framework that lets most ETFs launch without individual relief, provided they meet conditions such as daily portfolio transparency.