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Learn the stock market › Funds, ETFs and bonds › Lesson 3 of 7

What is an ETF?

Short answerAn ETF, or exchange-traded fund, is a fund whose shares are bought and sold on an exchange during the day, just like a stock. Most follow an index. You pay the fund's yearly fee, plus the spread and any commission when you trade, so $1,000 held for a year cost $12.90 against $2.00 for an index mutual fund in the example below.

A fund, traded on the exchange

A mutual fund sells and buys back its shares once a day, at that day's NAV. An ETF instead has a price that moves all trading day. You place an order and buy from someone who is selling, through the order book.

The price stays close to the fund's NAV because large broker-dealers, which the SEC calls authorized participants, can create new ETF shares by handing the fund a basket of its stocks, or hand shares back for the stocks. If the price drifts away from the NAV, they profit from closing the gap. The price can still sit a little above or below it, which is called trading at a premium or a discount.

What it costs

A made-up example: $1,000 in an ETF and in an index mutual fund, both charging 0.2% a year. The ETF is bought with the same made-up flat fee as in the lesson on commissions, and has a spread of 0.1%. The mutual fund charges nothing to buy or sell.

CostETFIndex mutual fund
Commission to buy$4.95$0.00
Commission to sell$4.95$0.00
Spread, 0.1% of the amount$1.00$0.00
Fee for one year, 0.2%$2.00$2.00
Total$12.90$2.00

Many US brokers charge no commission on ETFs, and then only the spread and the yearly fee remain. Where a flat fee applies, it weighs most on small orders. How to work out your own is in the lesson on commissions. The yearly fee is the cost that grows with time and the amount, see what fees cost over 30 years.

What ETFs can do

  • Trade during the day, with a limit order if you want to set the price.
  • Cover many markets, commodities and bonds, including some that few mutual funds follow.
  • Usually show their full holdings every day.

Some exchange-traded products are not funds, such as leveraged notes. They do not follow an index the same way and carry other risks; the lesson on leveraged ETFs covers them.

Test yourself

You buy shares of an ETF at 2 p.m. on an ordinary trading day. What price do you pay?

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