Investopedia: DEFINITION of 'Exchange-Traded Fund (ETF)'

Exchange-Traded Fund (ETF)
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DEFINITION of 'Exchange-Traded Fund (ETF)'

An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.

Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.
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BREAKING DOWN 'Exchange-Traded Fund (ETF)'

An ETF is a type of fund that owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual investment vehicle structure (such as a corporation or investment trust) will vary by country, and within one country there can be multiple structures that co-exist. Shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.

ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated. The ownership of the fund can easily be bought, sold or transferred in much the same was as shares of stock, since ETF shares are traded on public stock exchanges.

Find the right broker to trade ETF by reading Investopedia's broker reviews.
ETF Creation and Redemption

The supply of ETF shares is regulated through a mechanism known as creation and redemption. The process of creation/redemption involves a few large specialized investors, known as authorized participants (APs). APs are large financial institutions with a high degree of buying power, such as market makers that may be banks or investment companies. Only APs can create or redeem units of an ETF. When creation takes place, an AP assembles the required portfolio of underlying assets and turns that basket over to the fund in exchange for newly created ETF shares. Similarly, for redemptions, APs return ETF shares to the fund and receive the basket consisting of the underlying portfolio. Each day, the fund’s underlying holdings are disclosed to the public.
ETFs and Traders

    Since both the ETF and the basket of underlying assets are tradeable throughout the day, traders take advantage of momentary arbitrage opportunities, which keeps the ETF price close it its fair value. If a trader can buy the ETF for effectively less than the underlying securities, they will buy the ETF shares and sell the underlying portfolio, locking in the differential.
    Some ETFs utilize gearing, or leverage, through the use of derivative products to create inverse or leveraged ETFs. Inverse ETFs track the opposite return of that of the underlying assets – for example the inverse gold ETF would gain 1% for every 1% drop in the price of the metal. Leveraged ETFs seek to gain a multiple return of that of the underlying. A 2x gold ETF would gain 2% for every 1% gain in the price of the metal. There can also be leveraged inverse ETFs such as negative 2x or 3x return profiles.

Advantages of ETFs

By owning an ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share (there are no minimum deposit requirements). Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.

There exists potential for favorable taxation on cash flows generated by the ETF, since capital gains from sales inside the fund are not passed through to shareholders as they commonly are with mutual funds.
Examples of Widely Traded ETFs

    One of the most widely known and traded ETFs tracks the S&P 500 Index, and is called the Spider (SPDR), and trades under the ticker SPY.
    The IWM tracks the Russell 2000 Index.
    The QQQ tracks the Nasdaq 100, and the DIA tracks the Dow Jones Industrial Average.
    Sector ETFs exist that track individual industries such as oil companies (OIH), energy companies (XLE), financial companies (XLF), REITs (IYR), the biotech sector (BBH), and so on.
    Commodity ETFs exist to track commodity prices including crude oil (USO), gold (GLD), silver (SLV), and natural gas (UNG) among others.
    ETFs that track foreign stock market indices exist for most developed and many emerging markets, as well as other ETFs which track currency movements worldwide.

Next Up ETF Sponsor

    Exchange-Traded Fund (ETF)
    ETF Of ETFs
    Redemption Mechanism
    ETF Sponsor
    Reverse Gold ETF
    Bond ETF
    Oil Services Industry ETF
    Currency ETF
    No-Fee ETF
    Ultra ETF

ETF Of ETFs
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ETF of ETFs are exchange-traded funds (ETF) that track other ETFs rather than an underlying stock, bond, or index. Like a fund of funds, this new approach provides investors a method to invest in multiple different strategies with one product. It combines the cost and transparency advantages of the traditional ETF structure with the research and analysis of an actively managed fund. Many well established providers like Vanguard and Direxion have hopped on the bandwagon through new product offerings that combine different asset classes or rotate between sectors.
BREAKING DOWN 'ETF Of ETFs'

ETF of ETFs are tools that provide more diversification than regular ETFs. They can be constructed on certain desirable factors such as risk levels, time horizons or sectors. One of these financial instruments can give an investor broad exposure to many sectors and asset classes. On average, ETFs have lower fee structures whereas a managed fund tends to involve more research and analysis. An ETF of ETFs aims to strike a delicate balance between the two and beat a standard benchmark index.

The concept of an ETF of ETFs finds its roots in traditional target-date and other asset allocation funds that seek to provide simple investment solutions. An investment in a quality multi strategy fund is appropriate for novice investors who lack the skill or resources to construct an attractive portfolio in the current environment. The advantages don't end there. This novel approach affords investors instant diversification, low fees, and exposure to broad based strategies across different asset classes. In the event of a downturn, In the event of a downturn, a well diversified portfolio employing various strategies can help keep losses to a minimum
Limitations of 'ETF of ETFs'

While many of the newest ETF of ETFs claim to simplify investing, they often employ complex mechanisms that make it difficult to understand the various offerings in the fund. What's more, the products are often highly concentrated and tend to exhibit greater turnover than most actively managed funds. That means if the market turns against the fund, it could quickly become the largest holder of a thinly traded ETF. A more straightforward—and cheaper—approach involves constructing a portfolio of individual stock and bond ETFs. Moreover, investors must rely on the skill of the portfolio manager to make critical asset allocation and tactically adjust the portfolio on a timely basis. Most empirical research finds a hands-off, buy and hold approach tends to outperform a stock picking strategy.




Redemption Mechanism
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Refers to how market makers of exchange traded funds (ETF) can reconcile the differences between net asset value (NAV) and market values when shares of the ETFs are bought and sold. The market maker can arbitrage the ETF shares with the shares that make up the underlying portfolio, or by buying or redeeming lots of the ETF shares. This structure causes ETFs to be treated as "in kind" transactions where investors only pay capital gains like with stocks, as opposed to other fees associated with mutual funds.
BREAKING DOWN 'Redemption Mechanism '

This mechanism allows ETFs to be unique from mutual funds or unit investment trusts. Mutual funds can only be bought or sold for the NAV, which is calculated at the end of the trading day. Unit investment trusts can trade more fluidly, however the structure allows them to trade away from the NAV of the underlying portfolio. The redemption mechanism of ETFs causes neither of these problems to occur. ETFs trade liquidly on the exchange, and do not stray far from the NAV, because the market makers can so easily arbitrage the difference.
ETF Sponsor
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The company or financial institution which creates and administers an exchange-traded fund.

To set up the ETF, the sponsor creates the underlying index around which the ETF will be passively managed. The initial securities chosen for the fund are then delivered to the ETF sponsor by various institutional investors, who in exchange receive creation units – large blocks of ETF shares numbering 100,000 or more.

The holders of the creation units then market individual ETF shares to retail investors via the open market (stock exchanges); the ETF sponsor typically will deal only with the creation units and institutional shareholders and will not trade shares directly with retail investors.
BREAKING DOWN 'ETF Sponsor '

ETF sponsors have created quite a large industry for themselves in the time since the introduction of the first ETF, in 1993. Some of the larger, more diversified ETF sponsors may hold a portion of a fund's securities in-house, while others are more strictly focused on marketing, index maintenance and market liquidity. The sponsor also redeems physical securities for creation units should the holders of the creation units wish to make the swap.

When changes need to be made to an ETF portfolio due to changes in the underlying index, the sponsor will work with its creation-unit holders to exchange securities out for new ones that will reflect the updated index.
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