An exchange-traded fund, or ETF, is a fund that holds a basket of assets and trades on a stock exchange, the same way a share does. Most ETFs track an index, such as a national or sector index, by holding its components or a representative sample of them. A single purchase gives exposure to many holdings, which is why ETFs are a common starting point for investors who do not want to pick individual shares.
This guide explains what an ETF holds, how its price stays close to the value of those holdings, what the costs are and when an ETF may or may not suit a particular investor. It uses illustrative figures and does not recommend any fund. Structures and rules vary between countries, so read the fund's own documents before you buy.
What is an ETF?
An ETF is a fund with a stock market listing. It can hold shares, bonds, commodities or a mix of these, and some hold other funds or use contracts to reach the return of an index. Most people encounter ETFs that track an index, where the aim is to match the index's return before costs.
Structure varies: some are physically backed and hold the assets directly, while others are synthetic and use contracts. Some are actively managed, which means a manager picks the holdings.
Because ETFs trade during market hours, their price can move through the day, unlike a fund that is priced once a day at the close. That is convenient, since you can buy or sell at a known price during trading. It also makes it easy to trade more often than the investment requires, and many investors who trade ETFs frequently find that their results fall behind a simple holding.
How does an ETF's price stay close to its value?
An ETF's price usually stays close to the value of its holdings, called the net asset value, because large investors known as authorised participants can create new units or redeem existing ones. If the price drifts far above the value, these participants can create units and sell them to lock in the difference, which pushes the price back down.
If it drifts far below, they can buy units and redeem them, which pushes the price up. The gap between price and value is the premium or discount.
In normal conditions the premium or discount is small. In stressed markets, or for funds holding thinly traded assets, the gap can widen, and a buyer may pay more than the holdings are worth at that moment. Check the price against the published net asset value, and look at the spread between the buying and selling prices before you place an order.
Tracking difference is the gap between the ETF's return and its index's return over time. It reflects fees, cash held in the fund, sampling and trading costs. An ETF with a small tracking difference is doing its job more closely. Compare the tracking difference across similar funds, because two funds that track the same index can deliver different results.
What costs should you check?
The main ongoing cost is the expense ratio, a yearly charge taken from the fund's assets. It is deducted from the fund, so you do not see a separate bill, but it reduces the return every year. A 0.5 percent expense ratio on a 10,000 holding is 50 a year, paid whether the market rises or falls.
Over many years that cost compounds, so it matters a great deal.
Trading costs include the bid-ask spread and any broker commission. A wide spread on a thinly traded ETF can cost more than the expense ratio if you hold for a short period. Taxes on dividends and gains depend on your residence and on the fund's structure, so check the rules where you live before you assume an ETF is tax-efficient. The expense ratio guide explains how to read the full cost of a fund.
When is an ETF a good fit?
An ETF can suit investors who want broad, low-cost exposure to a market and do not want to pick single shares. It is less suited to people who plan to trade often, or who buy narrow or complicated products without understanding how they work.
Leveraged and inverse ETFs, for example, are designed for short-term use and can behave very differently over longer periods.
The fit depends on your goal, your timeline and your tolerance for losses. A broad index ETF held for many years is a different proposition from a sector fund bought to chase a recent rally. Before you buy, write down what the fund is for, how long you plan to hold it and what you will do if it falls by a large amount.
The table below uses illustrative figures to show how costs add up for two funds with the same gross return but different expense ratios.
| Item | Fund A | Fund B | What it means |
|---|---|---|---|
| Amount invested | 10,000 | 10,000 | The same starting sum |
| Gross return before costs (one year) | 8% | 8% | Assumed equal for the comparison |
| Expense ratio | 0.2% | 1.0% | Yearly charge taken from the fund |
| Net return after the expense ratio | 7.8% | 7.0% | The return you keep |
| Value after one year | 10,780 | 10,700 | The difference is 80 in one year |
The gap looks small in one year, but it compounds. The example is illustrative and ignores spreads, taxes and tracking differences, which can change the comparison.
How do you choose between two ETFs that track the same index?
Start with the cost, the tracking difference and the liquidity. Two funds that follow the same index can differ in fees, in how closely they match the index and in how easily their units trade. A small difference in cost can add up over many years, so the cheapest fund is often the right starting point.
Look at the size of the fund and its trading volume. A small fund may close, and a thinly traded fund may have a wide spread. Check the index provider and the methodology, since two funds with similar names may track different indexes and deliver different results.
Common mistakes
Buying a fund without checking what it holds. The name of an ETF does not always describe its holdings or its risk. Read the factsheet.
Ignoring the spread. A narrow headline price can hide a wide spread, which is a cost you pay each time you trade.
Treating an ETF as safe by default. An ETF that tracks shares carries the risk of those shares, and a leveraged product can lose value quickly.
Checklist
- Read the fund's factsheet for its holdings, index, structure and expense ratio.
- Check the premium or discount to the net asset value on the day you buy.
- Look at the tracking difference over several years, not one.
- Compare the expense ratio with similar funds that track the same index.
- Check the bid-ask spread and avoid buying in very thin trading.
- Confirm the tax treatment of dividends and gains in your country.
- Write down your holding period and what you will do after a large fall.
Key takeaways
An ETF is a fund that trades on an exchange, usually tracking an index, so one purchase gives exposure to many holdings. Its price stays close to the value of its holdings through creation and redemption, but gaps can widen in stressed markets. The expense ratio, the spread and the tracking difference all reduce what you keep, and the fit depends on your goal, timeline and tolerance for loss.
This guide is for general information, not financial advice. See the disclaimer.