How Exchange-Traded Funds Work

How Are ETFs Created?

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.