Definition
An exchange-traded fund (ETF) is an investment fund whose shares trade on a stock exchange like a single stock, while the fund itself holds a basket of assets such as stocks, bonds or commodities.
How it works
Most ETFs follow a rule, such as tracking a market index, a sector, a commodity price or a defined strategy. The fund holds the underlying assets, or instruments that copy their returns, and divides ownership into shares. Investors buy and sell those shares during trading hours at market prices, just like stocks.
The value of the fund's holdings per share is called net asset value (NAV). The market price stays close to NAV through creation and redemption: large financial firms called authorized participants can deliver assets to the fund in exchange for new ETF shares, or return shares in exchange for the underlying assets. If the price drifts away from NAV, this process makes it profitable to close the gap.
Costs come in two main forms. The expense ratio is a yearly fee, stated as a percentage of assets and deducted gradually from the fund. The bid-ask spread is paid when trading and tends to be wider for small or rarely traded ETFs. Leveraged and inverse ETFs aim for a multiple, or the opposite, of a daily return. Because they reset every day, their results over weeks or months can differ greatly from that multiple of the index return.
Example (hypothetical numbers)
Suppose you hold $10,000 in ETF X, which tracks an index and has an expense ratio of 0.20% a year.
Yearly cost ≈ $10,000 × 0.20% = $20, taken gradually from the fund's assets rather than billed to you.
ETF Y aims for 2× the daily return of the same index. Over 2 days the index goes from 100 to 110 (+10%) and then to 99 (−10%), a total change of −1%.
ETF Y goes from 100 to 120 (+20%) and then to 96 (−20%), a total change of −4%, not 2 × −1% = −2%.
Fees and daily resets both make an ETF's result over time differ from the simple index return.
Common mistakes
- Assuming every ETF is a broad, low-risk index fund regardless of what it holds.
- Holding a leveraged or inverse ETF for months and expecting exactly 2× or −1× the index return.
- Ignoring the bid-ask spread when trading thinly traded ETFs.
- Comparing ETFs by price per share instead of by holdings, costs and tracking quality.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.