What is an ETF, and why does its price differ from its value?

What is an exchange-traded fund?#

The SEC's Investor.gov describes an ETF as an exchange-traded investment product that must register with the SEC as an open-end investment company or a unit investment trust^[1]. Like a mutual fund, it pools money from many investors and invests in stocks, bonds, money-market instruments, other assets or a mix^[1]. Each share represents part ownership of the portfolio and the income it generates^[1].

The difference is how you get in and out. FINRA notes that ETFs are listed on an exchange, can be traded throughout the day, and generally do not sell shares to, or redeem shares from, retail investors directly^[2]. You buy from another investor through a brokerage account, the same way you would buy a stock^[1].

Most ETFs follow an index. FINRA says the vast majority of exchange-traded products are designed to track a market index or benchmark and are similar to index mutual funds^[2]. Others are actively managed: the adviser picks holdings without trying to match an index^[3]. See index funds explained for how tracking works.

How do ETF shares get created and traded?#

An ETF lives in two markets at once. In the primary market, typically only large firms called Authorized Participants buy and redeem shares directly from the ETF^[3]. To get new shares, an Authorized Participant deposits a designated basket of securities and cash with the ETF and receives ETF shares in exchange^[3].

In the secondary market, everyone else trades those shares on an exchange. Retail investors can only buy and sell ETF shares in market transactions^[3]. Because the shares trade all day, you can see a price before you place an order; with a mutual fund you get the next end-of-day NAV instead^[4].

Why can an ETF's market price differ from its NAV?#

An ETF has two numbers. Net asset value (NAV) is the value of what the fund owns minus what it owes, per share; see net asset value. Market price is what buyers and sellers agree on right now. The SEC notes the market price typically will be more or less than NAV per share, called selling at a premium or a discount^[3]. So you may pay more or less than NAV when buying, and get more or less when selling^[1].

What keeps the gap small most of the time is arbitrage — taking advantage of a price difference between two markets. When Authorized Participants trade on a gap, the ETF's market price moves back in line with its NAV^[3]. It is not a guarantee: FINRA warns that retail investors may trade at prices that deviate, sometimes significantly, from the underlying value^[2].

What does it cost to own an ETF?#

Like a mutual fund, an ETF takes its operating costs out of fund assets: funds pass costs to investors by deducting fees and expenses from NAV^[1]. That yearly cost is the expense ratio. FINRA notes that ETFs have expense ratios but do not have loads or 12b-1 fees^[2].

Trading adds costs that a fund's fee table does not show. You may pay brokerage commissions and other trading costs when you buy and sell^[3]. And there is the bid-ask spread: the bid is lower than the ask, and the SEC calls the spread a hidden cost because it reduces potential returns^[3].

In the U.S., ETFs that rely on SEC Rule 6c-11, adopted in 2019, must provide daily portfolio transparency on their website, along with historical premium and discount data and bid-ask spread information^[6]. When the rule was adopted, the SEC counted approximately 2,000 ETFs with over $3.3 trillion in net assets^[6].

What risks do ETFs carry?#

The wrapper does not change what is inside. ETFs are not guaranteed or insured by the FDIC or any other government agency, and you can lose money because the holdings can fall in value^[1]. A stock ETF moves with stocks; a bond ETF moves with bonds.

Some exchange-traded products add their own risks. FINRA explains that leveraged products aim for a multiple of an index's return and inverse products aim for the opposite, usually over a set period such as one day, and are generally not designed to be held for periods that differ from that^[2]. Exchange-traded notes look similar but are unsecured debt of a bank or other issuer, not pooled funds^[2].

What mistakes do beginners make?#

1. Assuming market price always equals NAV

   Prices can deviate from the fund's underlying value, sometimes significantly^[2]. A buy limit order can only execute at your limit price or lower^[7], which caps what you pay — though it may not fill at all.

2. Counting only the expense ratio

   The spread and any commission are paid every time you trade. In the worked example, one round trip through a $0.04 spread on 100 shares costs $4.00 — more than a full year of a 0.05% expense ratio on $5,000, which is $2.50.

3. Holding a daily leveraged ETF for months

   FINRA notes that leveraged and inverse products usually target a specific period, like one day, and are generally not designed to be held for periods that deviate from that^[2]. Read what holding period the product is designed for.