Overview

An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product; i.e., it is bought and sold on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, cryptocurrency, debt, and futures contracts, as well as commodities such as gold bars. ETFs provide more diversification than owning an individual stock and more market liquidity than owning an individual bond.

Most equity and fixed-income ETFs are index funds; they use passive management to replicate the performance of a stock market index or bond market index. These indices can be broad-based, such as the S&P 500 or Nasdaq-100 or focus on a certain industry such as the technology industry or the financial industry, a certain quality such as growth stocks or value stocks, a certain market capitalization, a certain factor such as high dividend stocks or value, momentum, quality, and low volatility, or a certain theme such as climate change, cloud computing, robotics, electric vehicles, the gig economy, e-commerce, or renewable energy.

Other ETFs use active management, either by picking stocks or by the use of covered call strategies to generate income. For ETFs that invest in bonds, some will focus on government bonds, while others invest in corporate bonds or high-yield debt or focus on specific durations.

In the United States, actively managed ETF issuers are required by regulators to publish the composition of their portfolios on their websites daily, or monthly in the case of index fund ETFs, or quarterly in the case of active non-transparent ETFs. Unlike mutual funds, ETFs are priced continuously throughout the trading day.

Statistics

The United States is by far the largest market for ETFs. In the United States, there is $10.2 trillion invested in equity ETFs, $2.4 trillion invested in fixed-income ETFs, and $0.6 trillion invested in other ETFs. In Europe, there is $1.4 trillion invested in equity ETFs, $0.7 trillion invested in fixed-income ETFs, and $0.1 trillion invested in other ETFs.

In Asia-Pacific, there is $1.9 trillion invested in equity ETFs and $0.2 trillion invested in fixed-income ETFs, including $837 billion in China, $712 billion in Japan, $242 billion in Taiwan, $212 billion in Australia, $206 billion in South Korea, $122 billion in India, and $75 billion in Hong Kong. Trading in ETFs accounts for approximately one-third of the total dollar volume of stock market trading in the US, 11% of trading volume in Europe, and 13% of trading volume in Asia. Purchases and sales of underlying assets by ETFs can significantly affect the price of such underlying assets.

In the United States, the largest ETF issuers by assets are BlackRock iShares with a 29.5% market share, Vanguard with a 28.7% market share, State Street Global Advisors with a 13.4% market share, Invesco with a 5% market share, and Charles Schwab with a 4% market share.

Legal structure

An ETF divides ownership of itself into shares that are held by shareholders. Depending on the country, the legal structure of an ETF can be a corporation, trust, open-end management investment company, or unit investment trust. Shareholders indirectly own the assets of the fund and are entitled to a share of the profits, such as interest or dividends, and would be entitled to any residual value if the fund undergoes liquidation. Shareholders also receive annual reports.

An ETF generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occur.

ETFs that invest in commodities are generally structured as exchange-traded grantor trusts, which gives a direct interest in a fixed portfolio. SPDR Gold Shares, a gold ETF, is a grantor trust, and each share represents ownership of one-tenth of an ounce of gold.

Investment structure

Most index ETFs invest 100% of their assets proportionately in the securities or assets that they intend to track, a manner of investing called replication. However, some ETFs instead use derivatives such as futures contracts, options, and swaps to track the underlying assets for all or a portion of their portfolios. This can lead to tracking error and may introduce counterparty risk. ETFs that engage in such practices include the Vanguard Total Stock Market Index Fund, the United States Oil Fund, some cryptocurrency ETFs, and synthetic ETFs.

Leveraged ETFs (LETFs) and inverse ETFs, use various financial engineering techniques, including equity swaps, derivatives, futures contracts, rebalancing, and re-indexing to seek a daily return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of an index with the result of significantly amplifying both risk and return. These funds must undergo daily rebalancing, selling after losses and buying after gains, and therefore are subject to volatility tax.

Arbitrage mechanism

ETF shares are created and redeemed when large broker-dealers called authorized participants (APs) create and redeem ETF shares directly (and in kind) from the ETF issuer in large blocks, generally 50,000 shares, called "creation units." The creation units mirror the underlying securities held by the ETF. Creation occurs when an authorized participant delivers the ETF’s underlying securities to the fund and receives new ETF shares. Redemption occurs when the authorized participant returns ETF shares to the fund and receives the underlying securities.

The AP's main incentive is profit through arbitrage: If the ETF trades above its underlying assets’ value, the AP creates new shares and sells them at the higher price. Conversely, if the ETF trades below its underlying assets' value, the AP buys ETF shares, redeems them for the more valuable underlying securities, and sells those. The spread between the price of an ETF and its underlying holdings occurs for multiple reasons including trading costs, and the time, risk, and fees involved in exchanging the securities.

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. APs provide market liquidity for the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares on the secondary market.

When new shares of an ETF are created due to increased demand, this is referred to as ETF inflows. When ETF shares are converted into the component securities, this is referred to as ETF outflow.