What is an ETF, really?
An ETF, or exchange traded fund, is a basket of investments you can buy and sell on a stock exchange in a single trade. This guide covers how ETFs work, their key benefits, how their liquidity actually functions, what they cost, the different types you can own, the risks to watch, and how they compare to other ways of investing.
ETF Basics
ETFs, in plain English
An ETF holds a basket of assets such as stocks, bonds, or other instruments, and trades on an exchange like a single stock. When you buy one share, you get proportional exposure to everything the fund holds.
ETFs trade throughout the day at market prices, so you can buy or sell whenever the market is open. Large institutions called authorized participants create and redeem shares in the background, which helps keep an ETF’s market price close to the value of its underlying holdings.
That structure is why ETFs are used for everything from broad index exposure to targeted income and thematic strategies.
An ETF at a glance
Trades like a stock
Buy and sell on an exchange in one trade.
Holds many assets at once
One share gives exposure to the whole basket.
Priced all day
Prices update continuously while markets are open.
Holdings are transparent
Most ETFs disclose what they hold every day.
Why ETFs
The benefits that won investors over
From humble beginnings in the 1990s, ETFs have become a core building block for individuals and institutions alike. A handful of structural advantages explain why.
01
Diversification
One share can give exposure to a wide range of stocks or bonds, helping spread risk across an index, sector, or country instead of a single name.
02
Low cost and easy access
Expense ratios often run low compared with mutual funds, anyone with a brokerage account can trade them, and there is typically no minimum purchase.
03
Intraday trading
Buy and sell any time the market is open, and know the price you will get without waiting for the close.
04
Tax efficiency
In kind creation and redemption can limit taxable events inside the fund, which may help reduce capital gains passed on to shareholders.
05
Price efficiency
Authorized participants and market makers arbitrage away premiums and discounts, keeping an ETF’s price close to the value of its holdings.
06
Transparency
Most ETFs publish their holdings daily, so you can see what you own. Semi transparent funds disclose an indicative value and a proxy basket instead.
Diversification does not guarantee a profit or protect against loss. Fees, trading costs, and tax treatment vary by fund and by individual circumstances.
Under the Hood
How ETFs actually work
When you place an order, shares can come from two places. The secondary market is buying and selling shares that already exist on the exchange. The primary market is where new shares are created or existing ones are redeemed. A few key players keep both running.
Investors
Individuals and institutions, the end buyers and sellers of ETF shares.
Issuers
The companies that sponsor a fund, list it on an exchange, and manage it.
Exchange
A regulated venue, such as Nasdaq, where shares are listed and traded. This is the secondary market.
Authorized participants
Firms allowed to create and redeem shares directly with the issuer, handing over underlying holdings to receive new ETF shares or vice versa. This is the primary market.
Market makers
Trading firms that post bids and offers all day, buying when investors sell and selling when investors buy, providing ongoing liquidity.
The farmers market analogy
Picture a stand selling corn. The seller can hand you bushels already on the table, the secondary market, or ask the farm to bring more in from the field, the primary market. So an ETF’s visible trading volume is only part of the story. Its true liquidity also reflects the volume of its least traded underlying holding.
Creation
When demand is high, an authorized participant delivers the underlying securities to the issuer and receives new ETF shares, adding to the shares trading on the exchange.
Redemption
In reverse, an authorized participant returns ETF shares to the issuer and receives the underlying securities, removing those shares from the exchange.
The bid is the highest price a buyer will pay, the ask is the lowest price a seller will take, and the gap between them is the spread, your cost to trade. ETFs with higher volume and more liquid holdings tend to have narrower spreads. Because issuers and authorized participants pass securities in and out of the fund in kind rather than selling them back and forth, ETFs can be more tax efficient than mutual funds. Always consult a tax professional for advice specific to your situation.
Costs
What do ETFs cost?
ETF costs come mostly from two places: the fund’s expense ratio and the cost of trading. The expense ratio is an annual fee, shown as a percentage of assets, that covers running the fund. Trading costs come from the bid ask spread and any premium or discount to net asset value at the moment you trade.
Expense ratios vary widely by strategy. Broad index ETFs tend to sit at the low end, while specialized, leveraged, or actively managed strategies generally cost more because they do more.
Expense ratio
The yearly fee to own the fund, taken from fund assets, not billed to you directly.
Bid ask spread
The small gap between the buy price and the sell price each time you trade.
Types
Active, passive, and smart beta
Most ETFs were passive for years, but active products are a growing share of the market. The label tells you how the fund makes its buy and sell decisions.
Passive
Track an index
Follows a rules based methodology to mirror an index or sector. Does not try to beat the market and often carries very low fees.
Active
Aim to outperform
Professional managers make buy and sell calls in pursuit of a benchmark beating return, often at somewhat higher fees.
Smart beta
A rules based hybrid
Codifies active style screening and weighting rules into an index the fund then tracks, blending elements of both approaches.
How passive funds replicate an index
Full replication
Holds every security at the same weight as the index.
Optimization
Holds a representative sample when an index is too large or hard to trade in full. Common for fixed income.
Synthetic
Uses derivatives to swap for the index return rather than owning the securities directly.
The trends in the data
Active vs Passive
ETF assets under management, $ billions
Source: Nasdaq, as of October 2023. Figures approximate, for illustration.
Smart Beta
Number of factor ETFs launched per year
Source: Nasdaq, as of October 2023.
As demand has grown, some mutual funds and separately managed accounts have converted into ETFs to gain intraday trading, daily transparency, and potential tax efficiency. Conversions can involve operational hurdles and, in some cases, shareholder approval.
2021
0
fund to ETF conversions
2022
0
fund to ETF conversions
2023*
0
fund to ETF conversions
*Through October 2023. Source: Nasdaq.
Risk
Is your ETF doing its job?
All investing carries the possibility of loss. Beyond that, a few metrics help you judge whether a fund is meeting its objective. Knowing the number is only half the job, the other half is putting it in context.
Passive
Tracking difference
The gap between a fund’s performance and its index over a set period. The expense ratio, cash drag, sampling, and trading costs all feed into it. For a passive ETF this is arguably the metric that matters most.
Passive
Tracking error
The volatility of that tracking difference. A low number means the gap is steady rather than swinging around. A small but bumpy difference can still show a high tracking error.
Both
Beta
Volatility relative to the market, which sits at 1.00. Above 1.00 is more volatile than the market, below is less. A negative beta moves inversely, as inverse and some bond funds can.
Both
Standard deviation
How much returns vary around their average. Two funds can share the same average return while one rode a far bumpier path. Note that it captures both upside and downside swings.
Active
Alpha
Performance relative to a benchmark after adjusting for volatility, shown as a percentage. It is a window into the active part of a fund’s return.
Active
Sharpe ratio
Excess return earned per unit of risk taken. Higher is better, and a reading above 1 is generally considered good.
There is also liquidity risk. A fund concentrated in thinly traded securities, such as small companies with wide spreads and low volume, tends to be less liquid than one holding large, heavily traded names. These metrics are educational tools, not signals to buy or sell, and past performance does not predict future results.
Compare
ETF vs mutual fund vs stock
ETFs, mutual funds, and individual stocks all give you market exposure, but they trade and price differently. Here is how the basics line up.
| Feature | ETF | Mutual fund | Stock |
|---|---|---|---|
| How it trades | On an exchange, all day | Once per day after close | On an exchange, all day |
| Pricing | Market price near NAV | At NAV, set once daily | Set by supply and demand |
| Diversification | Basket of holdings | Basket of holdings | Single company |
| Typical cost | Expense ratio plus spread | Expense ratio, sometimes loads | Commission or spread |
| Intraday trades | Yes | No | Yes |
Go Deeper
Leverage and options, explained
Some ETFs use leverage or options to pursue amplified or income oriented outcomes. These strategies behave differently from a standard index ETF and carry their own risks. We cover each in detail on its own page.
Leverage
Leveraged and 2X ETFs
How daily leverage works, why returns compound over time, and what that means for how long you hold.
Read the leverage guide
Options
Options, explained
What calls and puts are, how covered call income strategies work, and the trade offs involved.
Read the options guide
FAQ
Common ETF questions
No. Both pool money into a basket of holdings, but an ETF trades on an exchange throughout the day at market prices, while a mutual fund is bought and sold once per day at its net asset value after the market closes.
While the market is open, yes. ETFs trade like stocks, so you can buy or sell during normal trading hours. Orders placed when the market is closed execute when it reopens.
It is the annual fee a fund charges to cover its operating costs, shown as a percentage of the assets you have invested. A 0.50% expense ratio works out to about $5 per year for every $1,000 invested.
NAV, or net asset value, is the per share value of everything the fund holds. An ETF’s market price usually trades close to its NAV thanks to the creation and redemption process.
Many do. If a fund holds dividend paying stocks or generates income through its strategy, it can pass distributions on to shareholders. The amount and schedule depend on the specific fund.
An ETF is a structure, not a guarantee. ETFs can hold conservative or aggressive assets, so the level of risk depends entirely on what is inside the fund. All investing involves the possibility of loss, including loss of the money you put in.
A passive ETF follows a set of rules to track an index or sector and does not try to beat the market, which usually means lower fees. An active ETF has managers who choose holdings in pursuit of outperforming a benchmark, often at somewhat higher fees.
For a passive fund, tracking difference shows how closely it follows its index and tracking error shows how steady that gap is. Beta and standard deviation describe volatility, while alpha and the Sharpe ratio help judge active funds. No single metric tells the whole story.
Issuers and authorized participants pass securities in and out of the fund in kind through creation and redemption rather than selling them for cash, which can limit taxable events inside the fund. Tax outcomes still vary by individual, so consult a tax professional.
Generally yes. Leveraged ETFs aim to multiply daily returns, which also multiplies losses, and their performance can drift from the underlying over longer holding periods. Our leverage guide explains why in plain terms.
Put the basics to work.
Browse the REX lineup of income, leveraged, and thematic ETFs.
This page is for educational purposes only and does not constitute investment, tax, or legal advice or a recommendation to buy or sell any security. All investing involves the possibility of loss, including loss of principal. ETFs, and in particular leveraged and inverse ETFs, carry distinct risks; investors should consider each fund’s investment objective, risks, charges, and expenses before investing. Read a fund’s prospectus before investing. REX Shares ETFs are distributed by Foreside Fund Services, LLC.
