What is an exchange-traded fund (ETF)?

An exchange-traded fund (ETF) is a product that pools money from many investors, holds a set of assets according to a stated objective, and at the same time lets fund shares be bought and sold on an exchange much like a stock.

Buying ETF shares usually gives indirect economic exposure to the fund's portfolio rather than direct acquisition of each asset within it. An ETF may track an index, or a manager may select assets actively; it may also cover only one industry, region, commodity or other particular theme. "ETF" therefore describes a product structure and a way of trading. It does not equate to being diversified by nature, nor does it indicate lower risk.

One ETF share represents a part of the fund's portfolio

An ETF first sets an investment objective, then holds securities, cash or other eligible assets in the manner specified by its prospectus — the product document setting out the investment objective, the scope of holdings, fees and principal risks. One fund share represents an investor's interest in that fund. What the fund holds, how much each asset accounts for, and whether it uses derivatives — contracts whose value changes with the price of other assets — depend on the specific product documents and cannot be judged from an ETF's name alone.

For example, an ETF tracking a broad equity index may hold the shares of many companies; a sector ETF may concentrate in one industry; and a commodity or crypto-asset-related exchange-traded product may hold spot assets, futures contracts or other instruments. All of them can trade on an exchange, but their underlying assets, legal structures and sources of risk are not the same.

ETF shares are also not equivalent to the underlying assets themselves. Holding shares in an equity ETF does not mean an investor is registered directly as a shareholder of every constituent company; holding a crypto-asset-related product does not mean an investor holds the corresponding digital assets in their own wallet or controls the private keys.

Ordinary investors trade on an exchange, while fund shares are created and redeemed at another level

In many ETF arrangements that use a creation and redemption mechanism, there are two connected levels:

• the secondary market: ordinary investors buy and sell ETF shares from other market participants through an exchange, and the execution price is formed by market buying and selling;
• the primary market: an authorized participant (AP) creates or redeems shares directly with the fund in large blocks. An AP is usually a large financial institution that has an agreement with the fund.

In arrangements of this kind, creating shares means an AP delivers a specified basket of assets or cash to the fund in exchange for a large block of ETF shares; redeeming works the other way, returning a large block of shares to the fund to obtain the asset basket or cash. Retail investors usually do not take part in this process directly. The name given to an AP, the creation unit, whether creation and redemption are in kind or in cash, and disclosure rules all vary with a product's legal structure and the jurisdiction it sits in. Investor.gov's explanation of how registered ETFs in the United States operate separates exchange trading from an AP's block creation and redemption as two levels.

A creation and redemption mechanism gives professional participants the opportunity to trade on the difference between an ETF's market price and the value of the underlying assets. Such trading usually pushes the two closer together, but it is not a price guarantee: when there is a market interruption, when an underlying asset is suspended, when trading sessions differ or when liquidity is insufficient, the difference may still widen.

Net asset value and trading price are not the same number

Net asset value (NAV) is the value per share obtained by subtracting liabilities from a fund's total assets and dividing by the number of shares issued. A fund usually calculates NAV at specified times and by specified valuation methods.

An ETF's market price, by contrast, changes with buying and selling during a trading session. A market price above NAV is called a premium; below NAV it is called a discount. A premium or discount describes the difference between two prices. It does not indicate that a product is necessarily cheap or expensive, and it cannot explain future performance on its own.

A trader will also see a bid quote and an ask quote. The difference between them is called the bid-ask spread, and it is part of the actual cost of trading. When trading is not active, when markets are volatile or when underlying assets are hard to price, a spread may widen. When examining an ETF, you should understand NAV, market price, historical premiums and discounts, and the bid-ask spread separately.

Tracking an index is not the same as reproducing the index's numbers

An index ETF aims to reproduce the performance of an index, but an index is only a measure calculated by rules and cannot be held directly. A fund has to obtain the corresponding exposure through actual holdings, a sampled portfolio or other contracts, and it also has to deal with fees, cash balances, index changes and trading costs.

An ETF's actual return may therefore differ from its target index's return. The difference in results over a period is usually called tracking difference; the degree to which that difference fluctuates over time is often called tracking error. Fees may create a continuing drag, and sampling, taxes, the timing of trades and market friction also affect the result.

An active ETF instead has a manager select and adjust assets under a strategy specified in the product documents, and does not undertake to reproduce any index. For index and active alike, "listed on an exchange" cannot indicate which management approach a fund uses.

How an ETF differs from a stock and a mutual fund

ETFs, individual stocks and mutual funds may all appear in a securities account, but they represent different things and trade in different ways.

Mutual funds may have different names and trading rules in different jurisdictions; the table above describes common structures and does not substitute for specific product documents. The U.S. Securities and Exchange Commission's note on the ETF rule likewise distinguishes shares traded at market prices on an exchange from creation and redemption carried out with the fund by an AP in creation units.

An ETF's risk comes from how it actually obtains exposure

An ETF is a container; it does not remove the risks placed inside it. To judge an ETF, you first have to see how it obtains its target exposure:

• direct holding: the fund actually holds the target stocks, bonds, commodities or other assets;
• sampled holding: the fund holds only a portion of assets that approximates the target index's characteristics;
• exposure through derivatives: the fund uses contracts such as futures and swaps, and the result is further affected by conditions such as contract rolls, margin and counterparties;
• active management: a manager changes holdings under a stated strategy, and the result depends on strategy execution and management decisions;
• leveraged or inverse structures: the product usually seeks a multiple of, or an inverse to, an index's single-day return, rather than a simple multiple of a long-term return.

The last of these is especially open to misunderstanding. After a daily reset, a multi-day result is affected by the order of each day's rises and falls and by compounding. Even if a target index returns to its starting point after a period, a leveraged or inverse product may not have returned to its starting point. FINRA's note on leveraged and inverse exchange-traded products stresses that such a product should be understood by the daily objective it states, and that a multiple cannot be applied directly to a longer period.

Fees are not only a management fee

An ETF's documents usually list annual operating expenses, but the actual cost and price deviation may also include:

• the management fee and other operating expenses the fund deducts from its assets;
• brokerage costs incurred when buying and selling ETF shares;
• the spread between a bid quote and an ask quote;
• the price deviation from buying at a premium or selling at a discount relative to NAV;
• the internal costs of a fund adjusting holdings, using derivatives or handling cash;
• taxes or other charges that may arise under different market and account rules.

Two ETFs with the same expense ratio may still differ in actual tracking results and trading costs. Investor.gov's note on fund fees lists brokerage commissions, the bid-ask spread and premiums or discounts to NAV as trading costs still to be watched beyond a fee table.

"Crypto ETF" is sometimes only an everyday label

Media and market materials often refer to a range of crypto-asset-related listed products collectively as "crypto ETFs", but a specific product may use an exchange-traded product (ETP), a trust or another structure. A product's name and its actual structure should be taken from its offering documents and exchange disclosures.

For example, one spot crypto asset ETP may have a trust hold crypto assets and then issue shares that can be bought and sold on a securities exchange; another product may obtain price exposure through futures contracts. These two kinds of product differ in asset custody, pricing, fees and how they track. Staff of the U.S. Securities and Exchange Commission note in their disclosure guidance on crypto asset ETPs that such products commonly exist as trusts holding spot crypto assets or related derivatives, and need to explain their benchmark, NAV method, custody and material risks.

Holding listed shares of this kind also differs fundamentally from holding coins directly: an investor trades product shares through a securities account, does not initiate onchain transfers directly, and usually cannot use those shares to make payments, stake or take part in onchain governance on the corresponding network. Holding coins directly, on the other hand, involves wallets, private keys, onchain fees and asset safekeeping, and these are likewise not how trading ETF shares itself works.

So when judging a "crypto ETF", the first step is not to look only at an abbreviation, but to establish its legal structure, actual holdings, spot or derivative exposure, custody arrangements, creation and redemption method, and applicable rules.

Judging an ETF means going from its objective through to its actual holdings

When reading a product, you can check in the following order:

1. investment objective: which index, asset or strategy it undertakes to track, and whether the objective is a single day or a longer period;
2. actual exposure: what the fund holds directly, and whether it uses sampling, futures, swaps, lending or leverage;
3. legal structure: whether it is a registered fund, a trust or another ETP, and which disclosure and asset safekeeping rules apply;
4. portfolio concentration: whether the number of holdings, the largest holding and the industry or issuer distribution match the impression a name gives;
5. price relationship: what the historical premiums and discounts between market price and NAV are, and what the bid-ask spread and trading volume are;
6. tracking results: whether past tracking difference came from fees, sampling, contract rolls or other factors;
7. total costs: what fees arise from trading and holding beyond operating expenses;
8. key service providers: what responsibilities the manager, custodian, index provider and counterparties each bear.

This information can usually be found in a prospectus, periodic reports, a fund's website and regulatory disclosures. Products with similar names may use entirely different structures; only by connecting the objective, the actual holdings and the legal documents can you know what a share truly represents.

An ETF can provide portfolio exposure, but does not automatically equal diversification

An ETF holding many assets may reduce dependence on a single security; but if its holdings are concentrated in the same industry, region, issuer or common risk factor, the portfolio may still move together. Several ETFs with different names may also hold a great many of the same assets.

The number of ETFs, the number of constituents and the actual degree of portfolio diversification are therefore not the same thing. Analysing the degree of diversification also means looking at weights, overlap in holdings and shared dependencies, rather than only counting fund or security names.

FAQ

Why can an ETF's price differ from NAV?

ETF shares have a market price formed by buying and selling on an exchange, while NAV is calculated from a fund's assets and liabilities. The trading session, liquidity, whether underlying assets are open for trading, and market volatility may all cause the two to differ. An AP's creation and redemption and the related trading usually push the price closer, but cannot guarantee the two are always equal.

Do all ETFs track an index passively?

No. Some ETFs track an index, some have a manager select assets actively, and some use leveraged, inverse or derivative strategies. You should examine the investment objective and the actual holdings rather than judging a management approach from "ETF" alone.

Does buying an ETF containing many assets count as being well diversified?

Not necessarily. Constituents may be concentrated in a few heavily weighted assets, and may share a dependence on the same industry, region or risk factor. You also have to examine weights, overlap in holdings and underlying dependencies.

Is a spot crypto asset ETP the same as holding coins directly?

No. A product's shares provide economic exposure obtained through securities markets; an investor usually does not control onchain assets or private keys directly, and cannot use the shares as onchain assets.

Does low trading volume certainly mean something cannot be traded?

You cannot reach that conclusion from volume alone. An ETF's tradability also relates to the bid-ask spread, market-making activity, the liquidity of underlying assets and creation and redemption capacity. That said, a wider spread or a market interruption may increase execution costs and price deviation.

Related concepts

Continue with digital asset, portfolio diversification and crypto token, or return to the Crypto Glossary.

Sources

• Investor.gov: Exchange-Traded Funds (ETFs) — a basic explanation of ETF share trading, AP creation and redemption, NAV and premiums or discounts.
• U.S. Securities and Exchange Commission: Exchange-Traded Funds — Small Entity Compliance Guide — listed trading, creation units, asset baskets and disclosure requirements under the U.S. ETF rule.
• Investor.gov: Mutual Fund and ETF Fees and Expenses — operating expenses together with trading costs such as commissions, spreads and premiums or discounts.
• FINRA: The Lowdown on Leveraged and Inverse Exchange-Traded Products — daily leveraged and inverse objectives, multi-day compounding and path differences.
• U.S. Securities and Exchange Commission staff: Crypto Asset Exchange-Traded Products — the legal structures, spot or derivative exposure, NAV, custody and scope of disclosure of crypto asset ETPs.