How Exchange-Traded Funds Work

An ETF is much like a mutual fund in that it's really a "basket" of numerous stocks and other investment assets combined into a single investment product. They can only be created by huge financial management institutions, partly due to Securities and Exchange Commission (SEC) rules -- and partly because only large firms have the assets necessary to put an ETF together.

First, the company plans out the ETF, deciding exactly what assets will be included and details such as fees and the number of shares it'll be creating. Then the SEC approves the plan. At that point, authorized participants can begin to buy shares of the ETF. While technically anyone could be an authorized participant, they're always large investment firms. ETFs don't sell their shares individually -- instead, they sell huge chunks of shares called creation units, which may contain tens or even hundreds of thousands of shares [source: NYSE].

Creation units aren't purchased. Instead, they're traded for the equivalent amounts of the assets that the shares represent. These shares are placed with a custodial bank, where a fund manager oversees them and takes a small percentage of the fund's profits. We'll explain how this "trade in-kind" concept is important later, when we talk about ETFs and taxes.

The authorized participants who now hold thousands of shares of the ETF can then trade those shares on the open stock market, selling them to individual investors. If they want to cash out, they have to buy up enough shares to make up their initial creation unit and simply trade the shares back to the ETF, receiving the equivalent assets in return.

Next, we'll explore the popularity of ETFs.

There are a number of reasons that an ETF might be a better investment option than either individual stocks or a mutual fund. Their primary advantage over individual stocks, of course, is that they allow the investor to purchase a diverse array of assets at once.

Mutual funds offer the same advantage, but ETFs are better than mutual funds in several ways. They're more flexible, since they can be traded on the stock market instead of being held until after markets close, the way mutual funds are. Savvy investors can buy and sell ETF shares quickly throughout the trading day in response to shifts in market value. Investors can also take advantage of different stock strategies with ETFs, such as selling them short, buying them on margin (borrowing money to buy stocks) and purchasing very small numbers of shares. Those things aren't possible with mutual funds.

The cost of running an ETF is usually lower than a mutual fund. The fees paid to the custodial bank, the manager, the authorized participants and other involved parties (known as the fund's expense ratio) are clearly explained in the ETF's prospectus. These fees tend to be fairly modest, at least compared to some mutual funds. This is mainly because the fund manager doesn't actively manage the ETF like he or she might with a mutual fund, and thus takes a smaller fee. Also, because the creation of shares and the exchange between the ETF and the authorized participants is an in-kind trade, it doesn't trigger the kinds of capital gains taxes that a more straightforward sale of stock might.

Because ETF shares are freely exchangeable for the assets that make up the ETF, the value of the shares never deviates very far from the value of the assets, known as net asset value (NAV). If the shares increase in value, authorized participants can trade in assets for more creation units to sell on the market. This creates an increased supply of the shares, which pushes the price back down. If the opposite occurs and the ETF's shares are trading for a value less than the NAV, the shares can be traded back to the ETF in exchange for the assets themselves. This makes it almost impossible for the ETF shares' value to drop too far below the assets' value, since investors can always just trade the shares for the actual assets.

In the next section, we'll talk about some actual examples of ETFs.

As of 2011, there are more than 700 ETFs available on the market. Many ETFs are based on a market index (an index is a basket of related stocks that are tracked together and typically represent a specific economic segment or industry) such as the S&P 500 Composite Stock Price Index. In fact, the earliest ETF was made of S&P 500 assets and is known as SPDR, or Spider. Other market indexes include the Dow Jones Industrial Average, the NYSE Composite Index, and the Nasdaq 100 Index.

Which ETF you choose to invest in depends on your investment plans and goals. Each ETF is designed with a different goal in mind. For example, the Total Stock Market VIPERs ETF tracks a large number of U.S. companies, and therefore is considered a good way to track (and invest in) the overall U.S. economy. The iShares MSCI EAFE ETF gives investors shares in a range of foreign companies, so it's considered a good investment if you're looking to diversify your portfolio by buying international stocks.

Most ETFs aim to match the return of a market index, but there are other types. Leveraged and inverse ETFs strive to match a multiple of an index's return, or an inverse multiple of the index's daily return. These are more complex investments that should be researched thoroughly -- in fact, the SEC has issued a warning to investors because these types of ETFs can be confusing [source: SEC].

If you're looking to get into the ETF market, it's fairly easy to do since they're traded openly. ETFs have been steadily increasing in popularity since their introduction. However, since they're made up stock assets, their value has been negatively affected by overall economic downturns -- and they could face similar problems in the future. Of course, no investment is immune to this vulnerability. You should also note that buying and selling ETF shares is subject to the same brokerage fees you'd incur trading any other stock.

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