How it works
The fund owns a basket, and the units together own the fund. If the basket is worth 100 million and there are one million units, each unit stands for 100 of holdings. That figure is the net asset value per unit.
On the exchange, a unit’s price is set by buyers and sellers, so it could drift away from the value of the basket behind it. What keeps it close is a mechanism called creation and redemption, which only large dealers approved by the fund, known as authorised participants, can use.
If units trade above the basket’s value, a dealer can buy the basket’s holdings in the market, hand them to the fund and receive newly created units, then sell those units on the exchange. The extra supply pushes the unit price down towards the basket’s value. If units trade below it, the dealer does the opposite: buys units cheaply, hands them back to the fund for the holdings, and sells the holdings. Units are cancelled and the price is pushed up.
The dealer does this for the small difference, not as a service, so the gap closes only as far as the dealer’s own costs allow. Ordinary investors never create or redeem: they buy and sell existing units on the exchange.
What it costs
- The fund’s ongoing charge, taken from the fund’s assets each year and stated as a percentage.
- The spread between the buying and selling price of a unit on the exchange.
- A dealing charge or commission on each purchase and sale, and often a platform charge for holding.
- Tracking difference: the amount by which the fund’s return falls short of, or occasionally exceeds, its index after all costs inside the fund.
- A currency conversion charge when the units are priced in another currency.
The risks
- An ETF falls when its holdings fall. The wrapper removes none of the risk of what is inside it.
- The unit price can move away from the basket’s value when the holdings are hard to trade or markets are under strain, and the mechanism that closes the gap can slow or pause.
- Some ETFs do not hold the basket itself but use a contract with a bank to deliver the index’s return. That adds the risk that the bank fails to pay.
- Leveraged and inverse products aim at a multiple of one day’s move. Over longer periods their result can differ greatly from that multiple.
- A narrow fund, one sector or one theme, is a concentrated holding in a diversified-looking wrapper.
Where people go wrong
- Assuming every ETF is a broad, low-cost index fund. The label covers narrow, complex and leveraged products too.
- Looking only at the ongoing charge and ignoring the spread and dealing costs, which matter more the more often one trades.
- Trading in and out because it is possible. Being able to deal every second is a feature of the wrapper, not a reason to use it.
- Not reading what the fund actually holds, or which index it follows and how that index is built.
- Holding several funds that own the same large companies and counting them as spread out.
Questions people ask
- What is the difference between an ETF and a mutual fund?
- Both pool money into a basket of holdings. A mutual fund is bought from and sold back to the fund itself, once a day, at a price worked out after the market closes. An ETF’s units are bought and sold between investors on an exchange throughout the day, at the market price of that moment.
- Why does an ETF’s price stay close to the value of its holdings?
- Because large approved dealers can exchange the basket of holdings for new units, or units for the basket. Whenever the unit price moves far enough from the basket’s value, doing so earns them the difference, and their dealing pushes the price back. The gap can still widen in stressed markets.
- Does an ETF pay dividends?
- The holdings may pay dividends or interest to the fund. A distributing fund passes these on to unit holders at set dates; an accumulating fund keeps them and buys more holdings, so the value of each unit rises instead.
The words on this page
A general explanation for study, with invented examples. Costs, taxes and rules differ by country, market and product, and the documents of the thing itself are what count. Educational information, not investment advice or a recommendation to trade.