ETFs & Funds · Beginner · 5 min

What is an ETF?

You can explain how an ETF differs from a traditional fund, how its price stays close to its NAV, and what premiums and discounts are.

A fund with a ticker

On your trading screen, an ETF looks exactly like a share: a short ticker, a price that moves during the day, a chart. You buy it with the same button.

Underneath, it is something very different: a whole fund, often holding hundreds or thousands of securities. ETFs have become one of the most popular ways to invest. This lesson explains what makes them different from traditional funds, and the clever mechanism that keeps their price honest.

Traded like a stock

An exchange-traded fund, or ETF, is a fund whose shares are listed and traded on a stock exchange.

With a traditional mutual fund, you buy from the fund and sell back to it, once a day, at the next NAV. With an ETF, you trade with other investors on the exchange, at any time during trading hours, at the current market price.

That raises a question: if anyone can trade ETF shares at any price, what keeps the price close to the value of the fund? The answer is a special group of dealers.

An authorized participant is a large financial institution, usually a broker-dealer, that has a contract with the ETF to create and redeem shares in large blocks. The SEC describes the mechanism:

Creating: the authorized participant delivers a basket of the underlying securities, or cash, to the fund and receives new ETF shares in return.
Redeeming: it returns ETF shares to the fund and receives the basket back.

When the ETF's market price is above the value of its holdings, the dealer can create shares cheaply and sell them at the higher price. When it is below, the dealer can buy ETF shares cheaply and redeem them. Both trades push the price back towards the value.

The gap between the two is the premium and discount: above the NAV is a premium, below is a discount. The SEC notes that you may pay more or less than the NAV when you buy, and receive more or less when you sell.

Arbitrage closes the gap

A fictional ETF holds shares worth exactly 100 per ETF share. A rush of buyers pushes its price to 100.40, a premium of 0.4%.

An authorized participant buys the underlying shares for 100 per ETF share.
It hands them to the fund and receives new ETF shares.
It sells those ETF shares on the exchange at about 100.40.

The extra supply pushes the price back towards 100. The dealer earns a small margin, and investors get a price that closely tracks the fund's value.

Common mistakes

Assuming you always pay the NAV. You pay the market price, which can differ, especially in stress.
Ignoring the spread. Like any listed security, an ETF has a bid and an ask.
Thinking an ETF is one company. It is a fund with many holdings.
Trading ETFs when their underlying market is closed. Prices are then harder to judge, as a later lesson explains.

The takeaway

An ETF is a fund that trades on an exchange all day. Large dealers create and redeem shares, which keeps its price close to its value.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the fund you can buy and sell during the trading day at a market price.

Tap the chart.

ETF shares trade on an exchange like a stock. Mutual fund shares are bought from the fund at the next NAV.
2An ETF's NAV is 100.00, but it trades at 100.40. What is that called?

Above the NAV is a premium, below is a discount. The SEC notes you may pay more or less than NAV when you trade.
3Who can create and redeem ETF shares directly with the fund?

Authorized participants deal in large blocks with the fund. Private investors trade ETF shares on the exchange.
4Why does an ETF's price usually stay close to its NAV?

If the price is above NAV, they create shares and sell them. If it is below, they buy and redeem. Both moves narrow the gap.

of 4 correct.