What is an ETF and how does it work?

How it works

An ETF (exchange-traded fund) pools a basket of assets and divides it into shares that trade on the exchange throughout the session, just like a stock. If an ETF tracks an index, such as the S&P 500, its price rises and falls with that index.

To keep the price from drifting away from the value of the assets it holds, institutions called authorized participants create or redeem shares whenever a gap appears. That’s why, in high-volume ETFs, the market price stays very close to the net asset value (NAV), that is, the value of the assets the fund holds.

Most index ETFs are passive: they don’t try to beat the index, only to track it, which is why they usually charge less than actively managed funds. There are also active ETFs, in which a manager decides which assets to buy and sell.

Most common types

• Broad index: they track the whole market or a large group of companies.
• Sector: technology, energy, healthcare, banks.
• Commodities and bonds: gold, oil, government debt.
• Leveraged and inverse: they aim to multiply, or invert, the daily move of their index.

Why traders use them

Large ETFs are among the most heavily traded instruments on the market, and that brings concrete advantages for active traders:

• Liquidity: you can get in and out easily, with a very tight spread.
• Fewer single-company surprises: an index ETF won’t jump 20% on one company’s earnings report, as a single stock can.
• Reading the market: comparing ETFs from different sectors shows where money is flowing in and which sectors are lagging.
• Broad exposure with little capital: a single position represents dozens or hundreds of companies.

On the flip side, a broad index ETF usually moves less than an individual stock, so daily moves are smaller.

The cost that takes itself

Every ETF charges an annual management fee (the expense ratio), which is deducted from the fund’s value without showing up as a separate charge.

Hypothetical example: with $10,000 invested, a 0.10% fee costs $10 a year; a 0.75% fee costs $75. For active traders another cost matters more: the spread. Low-volume ETFs can have a wide gap between the bid and the ask.

Why leveraged ETFs aren’t meant to be held

A 2x ETF aims to deliver twice the move of a single day, and it resets every day. Over time, that changes the result.

Hypothetical example: an index starts at 100, rises 10% to 110, and then falls 10% to 99. It lost 1%. The 2x ETF starts at 100, rises 20% to 120, and then falls 20% to 96. It lost 4%, four times as much, even though the index fell only 1%. In markets that go up and down without direction, this decay adds up. That’s why they are designed for short horizons, and they amplify both volatility and risk. They also tend to charge higher annual fees than traditional ETFs.