What is an ETF? How exchange-traded funds work

An exchange-traded fund (ETF) is a pooled investment that holds a basket of assets, such as stocks or bonds, and whose shares trade on a stock exchange like any single stock. Buy one share of an S&P 500 ETF and you own a small slice of a portfolio that holds all 500 companies in that index, in roughly the same proportions as the index itself.

That combination of a whole portfolio in one ticker, a price that updates all day, and usually low costs is why ETFs have become one of the most common ways people invest. This guide explains what an ETF actually is, the unusual machinery that keeps its market price close to the value of what it owns, how to read its price against its net asset value, and the main kinds of ETFs, including the ones that behave very differently from a plain index fund.

What an ETF is, in one picture

An ETF has two layers. Underneath is the fund: a legal entity, usually registered with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, that owns a portfolio and is run by an investment adviser. On top are the fund's shares, which are listed on an exchange such as the NYSE Arca or Nasdaq and trade between investors from 9:30 a.m. to 4:00 p.m. Eastern Time like shares of any company.

When you buy an ETF through a brokerage account, you almost never buy from the fund. You buy from another investor or a market maker on the exchange, exactly as you would buy Apple stock. The fund is not involved in that trade. That is the first big difference from a traditional mutual fund, where every purchase and sale is with the fund itself (see Mutual funds explained: NAV, share classes, loads and 12b-1 fees).

So how does the number of shares grow when demand rises? Through a separate behind-the-scenes market that ordinary investors never touch.

Creation and redemption: the machinery

An ETF's sponsor signs agreements with a handful of large financial firms, usually broker-dealers, called authorized participants (APs). Only APs may buy shares from the fund or sell shares back to it, and only in large blocks called creation units. The SEC's investor bulletin on ETFs gives 50,000 shares as an example of a creation unit size; the exact number is set by each fund.

Creation. To create shares, an AP assembles a basket of securities that mirrors the fund's portfolio (the fund publishes what the basket should contain each day), delivers it to the fund, and receives a creation unit of brand-new ETF shares in return. The AP can then sell those shares on the exchange.

Redemption. To redeem, an AP buys ETF shares on the exchange, delivers a creation unit to the fund, and receives the basket of underlying securities, or sometimes cash, in return. Those ETF shares are cancelled.

Most of these exchanges happen in kind: securities for shares rather than cash for shares. That detail matters for two reasons. It means the fund rarely has to sell its own holdings to meet redemptions, which keeps trading costs inside the fund low. And because handing over securities is not a sale, it lets the fund shed low-cost-basis shares without realizing capital gains, which is the root of most ETFs' tax advantage (covered in ETFs vs. mutual funds: costs, taxes, trading and which fits).

NAV versus market price

Every ETF has two prices worth knowing.

• Net asset value (NAV) per share is what the fund's holdings are worth, minus its liabilities, divided by its shares outstanding. It is calculated once a day, usually from closing prices.
• Market price is whatever the last trade on the exchange was. It changes every second the market is open.

Why the gap stays small: arbitrage

The creation and redemption process is what keeps the market price honest. Suppose heavy buying pushes an ETF's price to $50.20 while its holdings are worth $50.00 a share, a 0.4% premium.

Because several APs and market makers compete for that profit, premiums and discounts on large, liquid ETFs that hold liquid assets are usually measured in hundredths of a percent. The mechanism weakens when the underlying assets are hard to trade or are priced in a market that is closed. A US-listed ETF of Japanese stocks trades during New York hours while Tokyo is shut, so its NAV is based on prices that are hours old and its market price can drift further from it. Bond ETFs can show wider gaps in stressed markets, when the bonds themselves barely trade and the ETF price becomes the most up-to-date estimate of their value.

The rule that governs most US ETFs

For decades, each ETF needed its own exemptive order from the SEC to operate. In September 2019 the SEC adopted Rule 6c-11 under the Investment Company Act, effective December 23, 2019, which let most ETFs operate under one standard set of conditions instead. As of 2026, an ETF relying on the rule must, among other things:

• publish its portfolio holdings on its website every business day, before trading opens;
• disclose historical premiums and discounts of its market price to NAV;
• disclose bid-ask spread information; and
• adopt written policies before using custom baskets (creation baskets that differ from a pro-rata slice of the portfolio).

For an investor, the practical result is that you can look up exactly what a standard ETF owns today, and how far its price has strayed from NAV in the past, on the fund's own website.

The main types of ETFs

Two items in that table deserve a warning. Leveraged and inverse ETFs aim for a multiple of an index's return over one day, and only one day. Held longer, compounding makes their results drift away from the multiple, often badly in a choppy market. They are built for short-term trading, not buy-and-hold. And exchange-traded notes (ETNs) look like ETFs on a quote screen but are unsecured debt of the bank that issues them, so you take that bank's credit risk on top of the market risk.

A real example: SPY

The first US ETF, the SPDR S&P 500 ETF Trust (ticker SPY), launched on January 22, 1993 and began trading a week later. It holds the stocks in the S&P 500 and, as of October 2026, its sponsor State Street lists a gross expense ratio of 0.0945% a year, or about $9.45 a year on a $10,000 holding. SPY is organized as a unit investment trust, an older structure than most later ETFs, which use the open-end fund form. One visible difference is that SPY holds the dividends it receives in cash until it pays them out each quarter, rather than reinvesting them in the meantime.

You can see SPY's history on its Finabase symbol page, including the quarterly dividends it has paid since 1993 on the Dividends & splits tab.

Costs of owning an ETF

The expense ratio is the main ongoing cost: a percentage of your holding deducted from the fund's assets each year, so you never see a bill. Beyond it, an ETF investor can pay:

• Brokerage commissions, if your broker charges them to trade ETFs.
• The bid-ask spread: you buy at the ask and sell at the bid. On a heavily traded ETF this is often a cent; on a thinly traded one it can be much wider.
• Premiums and discounts: buying at a premium and selling at a discount is a hidden cost; the reverse is a hidden gain.

The SEC notes that ETFs rarely charge the sales loads and 12b-1 fees that some mutual funds do. Expense ratios and fund costs: what you pay and how it compounds works through how these costs compound.

Pitfalls to avoid

Assuming every ETF is diversified. An ETF of 25 biotech stocks is a concentrated bet in a convenient wrapper. Read what it holds.

Trading thin ETFs with market orders. For a fund that trades a few thousand shares a day, a market order can fill well away from NAV. A limit order caps the price you pay.

Trading at the open and close. Spreads are often widest in the first minutes after 9:30 a.m., before every underlying stock has opened and market makers can price the basket with confidence.

Holding a daily-reset product for months. Leveraged and inverse ETFs say in their prospectuses that they seek their target only for a single day.

Mistaking a low share price for a cheap fund. An ETF's price per share says nothing about its value. Two ETFs tracking the same index can trade at $50 and $500 and hold the same stocks.

How Finabase helps

Every ETF has a symbol page with its live quote, an interactive chart, its dividend history and news, the same as a stock. The comparison tool puts several symbols in one table and on one chart rebased to the same starting point, which is a quick way to see whether two funds that claim to track the same market really move together. The sector page ranks the S&P 500 sector indexes over several periods, useful context before looking at a sector ETF. Finabase is a research tool; it does not hold accounts or place trades.

Frequently asked questions

Is an ETF a stock?

No, but it trades like one. An ETF share is a share of a fund that owns many securities, while a stock is a share of one company. Both are bought and sold on exchanges through a brokerage account at market prices during the trading day.

Can an ETF go to zero?

A broad-market ETF would go to zero only if every company it holds became worthless at the same time. Narrow, leveraged and inverse ETFs can lose most of their value, and funds that attract too little money are sometimes closed and liquidated, which returns cash to holders at NAV.

Who are authorized participants?

They are large broker-dealers that have contracts with an ETF to create and redeem shares in big blocks. They are the only parties who deal with the fund directly; their arbitrage keeps the ETF's market price close to its NAV.

Do ETFs pay dividends?

Yes, most stock and bond ETFs pass along the dividends and interest their holdings earn, minus expenses, usually quarterly for stock funds and monthly for bond funds.

Summary

An ETF is a fund with a stock's trading wrapper: it holds a portfolio, but its shares change hands on an exchange all day at market prices. A behind-the-scenes market, in which authorized participants swap baskets of securities for blocks of new or cancelled shares, lets arbitrage keep the price close to the value of the holdings and lets the fund avoid selling securities to meet redemptions. Since 2019 most US ETFs operate under SEC Rule 6c-11, which makes their holdings and trading costs public every day. Most ETFs are simple index funds, but the wrapper also holds narrow, leveraged and complex products, so the first step with any ETF is to read what it owns and how it aims to behave.