What is an ETF? Everything You Need to Know

Learn how ETFs work, including their fees, how they’re created and how they’re taxed.

ETFs are unique investment securities that work like mutual funds but trade on an exchange like stocks. Combine those qualities with extremely low expenses and you have a versatile investment that can be used by any investor, from a beginner to a seasoned professional. Learn how ETFs work, including what they are, how they are created and how they are taxed. 

What Is an ETF? 

An ETF, which stands for “exchange-traded fund,” is an investment security that holds other investment assets, such as stocks or bonds. ETFs are pooled securities like mutual funds, but as the name suggests, ETFs trade similarly to stocks on an exchange. Most ETFs passively track a benchmark index, such as the S&P 500, while some are actively managed.

How ETFs Work

Here are the basics on how ETFs work: 

• Pooled security: Like mutual funds, investors pool money into a single portfolio that is professionally managed.
• Exchange-traded: Rather than receiving the net asset value (NAV) at the end of the trading day like mutual funds, ETFs trade like stocks on an exchange like the New York Stock Exchange (NYSE) or Nasdaq, meaning that you can buy or sell at any time of day the stock market is open. 
• Passively managed: Most ETFs passively track the performance of a benchmark index, such as the S&P 500. 
• Low cost: Since ETFs generally track an index, the operational costs are low, and the cost savings are passed along to the shareholders of the fund. 

How Are ETFs Created? 

In the typical creation of an ETF, a sponsoring ETF issuer enlists the help of an Authorized Participant (AP), which may be a broker-dealer or large financial institution. The AP will buy all the securities in the benchmark index. In exchange, the issuer gives the AP a block of equally valued ETF shares, called creation units, which commonly come in blocks of 50,000. 

In different words, it is the AP’s job to acquire the securities that the ETF issuer wants to hold. For example, if an ETF is designed to track the performance of the S&P 500 index, the AP will buy shares of all the S&P 500 constituents in the same weights as the index. 

The entire creation/redemption mechanism is a key aspect in understanding how ETFs gain exposure to the market, and it is this process that allows ETFs to be less expensive, more transparent, and more tax-efficient than mutual funds. 

How Do ETFs Track Their Benchmarks? 

ETFs track a benchmark index by holding all the securities in the index. To closely replicate the performance of the index, the ETF will hold the securities in equal proportion to their weighting in the index. For example, if Apple Inc (AAPL) represents 7% of the S&P 500 index, an ETF designed to track this index would hold 7% of the fund’s assets in AAPL shares.

Some ETFs track the price movement of a specific asset or commodity, such as oil or gold. To track price movement, these ETFs often invest in derivatives or futures contracts, rather than the commodity itself. If the ETF invests directly in a physical commodity, such as gold, it usually stores it in a vault at a physical location, such as Zurich, Switzerland, or London, UK. 

Do ETFs Pay Dividends? 

Many ETFs pay dividends, and some track a dividend index and hold only dividend-paying stocks. The way it works is the ETF collects the dividends and distributes them to the fund’s shareholders, usually on a periodic basis, such as quarterly. Investors may choose to receive the dividends, or they may reinvest the dividends to buy more shares of the ETF.

How Are ETFs Structured? 

To understand how ETFs work, it helps to know the different ETF structures. For example, an ETF’s ultimate tax treatment depends on its particular structure and the underlying asset it covers. ETFs generally come in one of five structures: open-end funds, unit investment trusts (UITs), grantor trusts, limited partnerships (LPs), and exchange-traded notes (ETNs). 

The five main ETF structures are: 

• Open-end funds: Most ETFs are structured as open-end funds, which typically provide investors with exposure to the main investment asset classes, such as stocks and bonds. Open-end funds fall under the authority of the Investment Company Act of 1940.
• Unit investment trusts: When structured as a UIT, an ETF invests pooled money coming from many investors in a one-time public offering, which will generally invest in a fixed portfolio of stocks, bonds, or other securities.
• Grantor trusts: ETFs investing in a single commodity, such as gold, are structured as grantor trusts, which are required to hold a set number of assets and cannot receive income.
• Limited partnerships: When ETFs are structured as a partnership, they may benefit from pass-through taxation, as they are unincorporated entities that are not subject to the double taxation of a corporation. Therefore, any realized gains or losses can flow directly to fund shareholders. Because of this flexibility, these ETFs often invest in commodities like oil or natural gas. 
• Exchange-traded notes: An ETF structured as ETN comes in the form of prepaid forward contracts designed to track an underlying index of securities. When you buy an ETN, an issuing bank promises to pay you a certain pattern of return. Thus, an ETN is an unsecured debt that works like a bond, but it is not secured to an asset. ETNs can also be used to gain exposure to niche markets like currencies and commodities.

How Are ETFs Taxed? 

How an ETF is taxed depends primarily on the fund’s underlying holdings and the form of distributions paid to shareholders. For example, a dividend ETF will be taxed on the dividends distributed. Investors may also incur capital gains tax on the profit earned from selling an ETF. The ultimate tax paid may also depend on the shareholder’s tax bracket. 

• Ordinary dividends: Taxed at the same rate as regular income, which depends on the investor’s tax bracket. 
• Qualified dividends: Taxed at a lower capital gains rate, which may range between 0% and 20%. 
• Interest payments: Payments from bonds and bond funds are taxed as regular income, as are ordinary dividends from stocks and stock funds. 
• Capital gains: Profits from selling shares of an ETF in a taxable brokerage account will be taxed at the capital gains rate, ranging from 0% to 20%. On rare occasions, ETFs distribute capital gains from the fund, which is taxable to the shareholder, even if they did not sell shares. 

It’s important to note that ETFs with non-traditional structures, such as commodity-based ETFs and exchange-traded notes (ETNs), are taxed differently than the more traditional open-end ETFs. For example, a commodity ETF structured as a grantor trust, such as the SPDR Gold Shares (GLD), will hold physical gold and will be taxed as a collectible, which will never qualify for the 20% capital gains rate. 

Another important note on ETF taxation is that taxes are not owed on ETFs while held in a tax-advantaged account, such as an individual retirement account (IRA) or a 401(k). 

Do ETFs Have Fees? 

ETFs have fees and are expressed as an expense ratio, which is a percentage representing a fund's assets used to pay its operating costs. From the investor’s perspective, an ETF’s expense ratio is the fees paid on an annual basis to own the fund. ETF fees average below 0.40%, and some charge less than 0.10%. 

For example, if you own an ETF with an expense ratio of 0.09%, your share of the fund’s fees is $9 for every $10,000 invested. But these fees do not come out of your pocket. So, if the fund returned 10% before fees, the return received by shareholders would be 9.91%.

ETFs are much cheaper than actively managed mutual funds, and on average, have lower expense ratios than index-based mutual funds. The reason ETFs are so cheap is that they are passively managed, and they trade seamlessly on an exchange, which is part of why they are less costly to manage than a mutual fund. 

What Are ETF Risks? 

The primary risk associated with investing in ETFs is market risk, which is the risk that adverse market conditions can cause a decline in the price of the fund. The specific degree of market risk with ETFs depends primarily on the underlying assets that they track. For example, a stock ETF will generally have more market risk than a bond ETF. 

How to Invest in ETFs 

To invest in ETFs, you will need an investment account. Like investing in stocks or mutual funds, your investment account may be an individual brokerage account, a joint brokerage account, or any variety of individual retirement account (IRA). Once you have the investment account open, you will need to fund it with cash, and you’ll be ready to invest in ETFs. 

The basic steps to invest in ETFs are: 

1. Open an investment account. 
2. Fund the investment account with cash. 
3. Select the ETF(s) to purchase. 
4. Execute the trade(s) to buy shares.

What to Know About ETFs: The Bottom Line

ETFs are relatively simple in how they work, but there are many aspects of these unique investment securities to understand before investing. The main things to know about ETFs are that they are a low-cost way to gain exposure to a broad market index or a narrow market niche, such as a sector or subsector.

What makes ETFs unique is that they are pooled securities like mutual funds, but they trade during the day on an exchange like stocks. Beyond the basics, investors are wise to consider how ETFs are taxed, and if they are suitable for their risk tolerance and investment goals.