An exchange-traded fund (ETF) is a trust that issues units/shares which trade on the stock exchange at a market-determined price. Investors may buy or sell ETF shares through a broker or in a brokerage account, just as they would trade the shares of any publicly traded company.
Two main types of ETF
The two main types of ETFs available are index ETFs and overseas actively managed ETFs (actively managed ETF’s are a newish phenomenon). An ETF represents a portfolio of assets, and the types of assets an ETF holds depend on its investment objective. ETFs can hold any type of financial asset. Some ETF’s are based on commodities and hold either commodity-based derivatives or physical commodities such as gold.
There are literally thousands of ETF’s listed on stock exchanges all around the globe, tracking nearly every conceivable asset class index, some let you bet on the asset class index decreasing in value rather than increasing, some are very heavily geared, some track some pretty obscure corners of the investing universe.
Most ETF’s licence the index they track from an outside vendor such as S&P, Frank Russell & Company, Dow Jones and Morgan Stanley Capital International (MSCI).
But actually the term “exchange traded fund” is not a precise legal term but a market term, rather like “hedge fund,” that takes in a range of investment vehicles differing from
each other in significant legal ways. For example the actual legal structure of US ETF’s is different to Australian ETF’s.
A wise investor reads the prospectus carefully and understands what they are investing their money in – Caveat Emptor!
ETF Stocks – A more complex explanation
An ETF unit represents an ownership interest in a commingled investment portfolio. The main difference between ETFs, shares and unlisted managed funds is the process via which new ETF units are created or redeemed. Read the article on How ETF’s Work for more information
The nuts and bolts of the creation redemption process is that whilst ETFs are bought and sold like a company during the day when the stock exchange is open, the market price of the shares is kept quite closely in line with their underlying security values, via an arbitrage mechanism, through which the market makers make a small profit.
In summary ETF stocks are bought and sold during the day like stocks when the stock exchange is open. The arbitrage mechanism of ETF’s ensures that investors pay a price close to the funds intraday indicative value. In terms of buying ETF stocks provided the spread between the bid and the ask price is only a few cents you are probably getting a fair price (refer to How to Buy ETFs article for more information regarding the spread and indicative value).