What is an ETF?

What is an ETF in simple terms?

The US Securities and Exchange Commission (SEC) describes it like this: “An ETF is a type of exchange-traded investment product available for retail investors.” Like a mutual fund, an ETF pools money from many investors and holds a portfolio — for example, the shares of all the companies in a stock index.

The difference is how you get in and out. According to the SEC, “ETF shares are traded throughout the day on national stock exchanges and at market prices.” You buy and sell them through a brokerage account, just like an individual company’s shares, rather than directly from the fund.

How is an ETF different from a mutual fund?

Both pool money: the SEC says ETFs, like mutual funds, “offer investors a way to pool their money in a fund that makes investments in stocks, bonds, other assets, or some combination of these investments.” On costs, the SEC’s 2023 ETF bulletin says “ETFs have tended to be less expensive to operate than mutual funds.” On tax, it adds: “ETFs typically have fewer capital gain distributions than mutual funds. As a result, ETF shareholders may pay less in taxes on a similar investment.” Tax rules depend on where you live.

How are ETF shares created?

Behind the scenes, large financial institutions called authorized participants deal with the fund directly. The SEC explains: “To purchase shares from an ETF, an Authorized Participant assembles and deposits a designated basket of securities and cash with the ETF in exchange for which it receives ETF shares.” They can also hand large blocks of shares back to the fund in exchange for the underlying assets.

This creation and redemption process is what normally keeps an ETF’s market price close to the value of its holdings. Ordinary investors never take part in it — you simply trade existing shares with other investors on the exchange.

Why can an ETF’s price differ from the value of its holdings?

A fund’s net asset value (NAV) per share, in the SEC’s words, is “the value of all its assets minus all its liabilities divided by the number of shares”. ETFs must calculate it every business day. An ETF’s market price is whatever buyers and sellers agree on the exchange. The SEC notes: “An ETF’s market price typically will be more or less than the fund’s NAV per share (called selling at a premium or discount).”

Authorized participants can trade directly with the fund at NAV as well as on the market, so they can profit from a gap. The SEC says “The expected result of the arbitrage activity is that the market price of the ETF’s shares moves back in line with the ETF’s NAV per share.” The gap is not always closed, though, and the SEC also warns that for some ETFs “there is a risk that a trading market may not develop at all”.

What does an ETF cost?

Three costs matter most:

• Expense ratio. The fund’s annual operating expenses as a percentage of its average net assets, shown in the standardized fee table in the prospectus. The SEC’s 2025 fees bulletin warns: “A fund with higher costs must perform better than a lower-cost fund to generate the same returns for you.”
• Brokerage commissions, if your broker charges them when you buy or sell.
• The bid-ask spread. The SEC calls it something that “can be thought of as a hidden cost to investors since spreads reduce potential returns.” See our explainer on the bid-ask spread.

An illustrative calculation, using made-up fee levels: on a $5,000 holding, a 0.50% expense ratio costs about $5,000 × 0.005 = $25 a year, while a 0.10% ratio costs $5,000 × 0.001 = $5. The fee is taken whether the fund rises or falls.

What is the difference between index and actively managed ETFs?

The SEC describes two main styles. Index ETFs “seek to track an underlying securities index”, such as a broad stock market index. In actively managed ETFs, the adviser can “buy or sell components in the portfolio without regard to conformity with an index.”

Neither is automatically better. What matters is what the fund holds, what it costs and whether it fits your goals. Remember that a fund is not automatically diversified: Investor.gov warns that a fund or ETF won’t necessarily provide diversification if it is narrowly focused, such as on one industry sector. Our guide to diversification covers this.

What are leveraged and inverse ETFs?

These are specialised products. The SEC explains: “Leveraged ETFs seek to deliver multiples of the daily performance of the index or benchmark they track”, while “Inverse ETFs seek to deliver the opposite of the daily performance of the index or benchmark they track.”

The word daily is crucial. Over longer periods, returns “can differ significantly” from the stated multiple. An illustrative two-day example:

• Index: +10% then −10% → 1.10 × 0.90 = 0.99, a 1% loss.
• A 2× daily leveraged fund: +20% then −20% → 1.20 × 0.80 = 0.96, a 4% loss — not 2 × 1%.

The SEC’s conclusion: “These are specialized products that generally are not suitable for buy-and-hold investors.”

Can you buy an ETF that holds crypto?

In the US, the SEC approved exchange rules in 2024 that let spot bitcoin and spot ether exchange-traded products list. These products are structured differently from ordinary ETFs and carry crypto’s risks. We explain the details in spot bitcoin and ether ETFs. For crypto itself, start with crypto risks.

What are the risks of investing in ETFs?

• Market risk. An ETF is only as steady as what it holds. A stock ETF can fall as sharply as the stock market.
• Premiums and discounts. You may buy above or sell below the value of the holdings.
• Liquidity. The SEC warns that for some ETFs a trading market may not develop at all, and the spread is a cost every time you trade.
• Costs. Expense ratios, commissions and spreads reduce returns every year.
• Complex products. Leveraged and inverse ETFs behave very differently over time from what their names suggest.
• Narrow focus. A single-sector ETF can be as concentrated as holding a few stocks.

The SEC’s advice: “Carefully read all of the fund’s available information, including its summary prospectus and full prospectus.”

Blockhorizon is an education site. Nothing here is a recommendation to buy, sell or hold any ETF or other investment.