2: How do ETFs work?

Although simple to buy and sell (through any brokerage account, like a stock), exchange-traded funds (ETFs) are based on an underlying mechanism that's very different from mutual funds:

  • When you buy mutual fund shares, you’re buying directly from the fund company which holds the individual securities that make up that fund. When you withdraw your money, your shares are ‘redeemed’ directly by the mutual fund company based on the Net Asset Value (NAV) of the securities.
  • When you buy ETF shares, you’re also buying shares which represent fractional ownership of a basket of securities. However, rather than buy or redeem them from the fund sponsor directly, you buy them on the open market, from one of many authorized ‘market makers.’
  • These market makers can create or redeem blocks of shares of the ETF ('creation units') anytime they want, based on the index composition determined by the fund sponsor, by buying or selling the underlying securities. They can also buy or redeem large ETF share blocks directly from the fund sponsor, tendering or receiving the underlying securities in return (an 'in-kind' transaction, which is what makes ETFs tax-efficient).
  • ETFs are approved and regulated by the The Securities and Exchange Commission. See the SECs ETF information page for information on specific legal structure of ETFs.