ETF Basics – How Exchange-Traded Funds Work

Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges like individual stocks. A single ETF can hold hundreds or even thousands of underlying securities, giving you instant diversification in one trade.

This guide explains ETF basics in plain language: what ETFs are, how they work, how they differ from mutual funds, common types of ETFs, costs, risks and where they fit into a long-term investing plan. For a wider foundation, see Investing 101 and What Are Stocks?.

What is an ETF?

An ETF is a pooled investment vehicle, similar to a mutual fund, that holds a basket of assets such as:

• Stocks
• Bonds
• Commodities or commodity futures
• Other securities or a mix of assets

Unlike traditional mutual funds, which are priced once per day, ETFs trade on stock exchanges throughout the trading day. You can buy and sell ETF shares at market prices using a brokerage account, just as you would with individual stocks.

How ETFs are structured and priced

Each ETF issues shares that represent ownership in the underlying portfolio. The value of the fund’s holdings divided by the number of shares is called the net asset value (NAV).

Two prices matter:

• NAV: the value of the underlying holdings per share.
• Market price: the price at which ETF shares trade on the exchange.

In liquid ETFs, market price typically stays close to NAV because of the creation and redemption mechanism:

• Authorized participants (large financial institutions) can deliver baskets of securities to the ETF in exchange for new shares (creation).
• They can also return ETF shares to the provider in exchange for the underlying securities (redemption).

This process helps keep the ETF’s trading price aligned with its underlying value, although small premiums or discounts can still occur.

ETF vs. mutual fund: what’s the difference?

ETFs and mutual funds are both pooled investments, but there are key differences:

• Trading: ETFs trade intraday on exchanges; mutual funds are typically bought and sold once per day at end-of-day NAV.
• Costs: Many ETFs have low expense ratios and no loads. Mutual fund costs vary widely and may include sales charges or higher MERs.
• Minimums: ETFs usually have no minimum beyond the cost of one share (and sometimes fractional shares). Mutual funds often have specific minimum investment amounts.
• Tax efficiency: In some regions, ETFs can be more tax-efficient due to in-kind creation/redemption mechanisms. Details depend on local tax rules.

For a deeper look at mutual funds, see our Mutual Funds Basics guide.

Index ETFs vs. active ETFs

Most ETFs fall into one of two broad categories:

• Index ETFs: designed to track a specific index (for example, a broad market, sector or bond index). They follow rules-based strategies and aim to match the index’s performance before fees.
• Active ETFs: managed by a team or strategy that selects holdings with the goal of outperforming a benchmark. Fees are generally higher and results may differ more from the broad market.

Many long-term investors use index ETFs as core holdings because of their diversification, transparency and relatively low costs.

Common types of ETFs

The ETF universe has grown rapidly. Common categories include:

• Broad market ETFs: track large, diversified indexes (for example, total-market or major country indexes).
• Sector and industry ETFs: focus on specific sectors like technology, healthcare or financials.
• Bond ETFs: hold government, corporate or other fixed-income securities. See also Bond Investing Basics.
• International and emerging markets ETFs: provide access to foreign markets in a single trade.
• Factor or smart-beta ETFs: tilt toward characteristics like value, growth, quality or low volatility.
• Thematic ETFs: focus on themes like clean energy, cybersecurity or specific trends. These can be more concentrated and speculative.
• Commodity and currency ETFs: provide exposure to commodities or currencies, sometimes using futures or derivatives.

ETF costs and fees

When evaluating ETFs, pay attention to:

• Expense ratio: the annual management fee as a percentage of assets (for example, 0.10% per year). Lower is generally better, all else equal.
• Trading costs: commissions (if any) and bid-ask spreads when buying and selling.
• Tracking difference: how closely the ETF’s actual performance matches its benchmark over time, after fees and operational costs.

Even small differences in expense ratios can add up over decades, especially for core holdings in retirement investing.

Liquidity and trading considerations

Liquidity affects how easily you can trade an ETF without significantly moving its price. Key points:

• Underlying liquidity: ETFs holding heavily traded securities tend to be more liquid and have tighter spreads.
• Bid-ask spread: the difference between buy and sell prices. Narrower spreads mean lower implicit trading costs.
• Trading volume: higher average daily volume often indicates better liquidity, but underlying holdings still matter more than ETF share volume alone.

Many investors avoid trading very close to the market open or close, when spreads can be wider, and are cautious around major news announcements.

Risks of investing in ETFs

ETFs share many of the same risks as their underlying assets, plus a few structure-specific considerations:

• Market risk: if the underlying market falls, the ETF will typically fall as well.
• Tracking error: the ETF may not perfectly match its benchmark due to fees, sampling methods or trading frictions.
• Liquidity risk: some niche or thinly traded ETFs can have wider spreads and be harder to enter or exit.
• Complex products: leveraged, inverse or derivatives-based ETFs can behave in ways that are not intuitive, especially over longer holding periods.

As an ETF basics rule, understand what an ETF holds and how it behaves before using it in your portfolio.

How ETFs fit into a long-term investing plan

Many investors use ETFs as core building blocks because they:

• Provide diversification in a single trade.
• Offer transparent, rules-based exposure to specific markets or asset classes.
• Can be combined to build a tailored asset allocation (for example, stock/bond mix).

A simple long-term portfolio might use:

• One or two broad stock index ETFs.
• One or two bond ETFs for stability.
• Optional satellite ETFs for specific tilts (for example, a sector or factor fund).

For more on big-picture planning, see Investing 101 and Retirement Investing Basics.

Common ETF mistakes to avoid

Even with ETF basics in place, investors sometimes:

• Buy narrow thematic or leveraged ETFs without understanding the risks.
• Overlap multiple ETFs that hold many of the same underlying securities.
• Focus only on recent performance instead of long-term fit and costs.
• Trade too frequently, turning a long-term tool into a short-term speculation.

A good starting point is to prioritise broad, low-cost, well-established ETFs for core holdings and treat more specialised products carefully.

ETF Basics FAQ

For a broader foundation, see Investing 101 and Retirement Investing Basics. To understand related building blocks, read What Are Stocks?, Mutual Funds and Bonds. For the higher-risk end of the spectrum, see our guides to Day Trading, Forex, Options and Futures. For quick definitions, visit our Dictionary Index.