What Is an ETF? How Exchange-Traded Funds Work

What is an ETF?

An exchange-traded fund (ETF) is an investment fund that pools money from many investors and uses it to hold a portfolio of assets, such as stocks, bonds, or other investments. Each ETF share represents an investor's interest in the fund and its portfolio.

Instead of purchasing every investment separately, an investor can buy shares of a single ETF and gain exposure to the investments held inside the fund. ETFs can follow very different investment strategies. Some may provide broad market exposure, while others may focus on a particular industry, asset type, country, or investment approach.

How does an ETF work?

When an investor buys shares of an ETF, the investor owns shares of the fund rather than directly owning each individual investment inside it. The value of the fund is influenced by the value of its underlying holdings, while ETF shares are bought and sold on an exchange at market prices that can change throughout the trading day.

How can an ETF generate income?

The investments held by an ETF may generate income. For example, stocks held by the fund may pay dividends, while bonds may generate interest. A fund may distribute income it receives from its portfolio to its shareholders, after fund expenses.

ETFs may also make other types of distributions, such as capital gains distributions. The amount and type of distributions can vary depending on the fund, its holdings, and its investment activity. Distributions are not guaranteed and can change over time.

Key terms

Important ETF terms

Understanding a few basic terms makes it easier to see what an ETF contains, how it trades, and what it may cost to own.

ETF Share

A share that represents an investor's interest in an exchange-traded fund and the portfolio held by that fund.

Underlying Assets

The investments held inside an ETF. Depending on the fund, these may include stocks, bonds, or other types of assets.

Expense Ratio

The annual operating expenses of a fund expressed as a percentage of its assets. These expenses are deducted from the fund's assets and reduce the investment return received by shareholders.

Index

A group of securities designed to measure or represent a particular market or part of a market. Some ETFs are designed to track the performance of an index.

Market Price

The price at which an ETF share can be bought or sold on an exchange. The market price can change throughout the trading day.

Distribution

A payment an ETF makes to its shareholders. Depending on the fund, distributions may include income such as dividends or interest, capital gains, or other amounts.

Fund composition

Inside an ETF

An ETF can hold many investments at the same time. Each investment can represent a different percentage of the fund depending on how the ETF is constructed.

This means that buying one share of an ETF can provide exposure to multiple investments, even though those investments may not have equal weight within the fund.

Educational example

Example ETF

100% total allocation

30%

25%

20%

15%

10%

Company A 30%

Company B 25%

Company C 20%

Company D 15%

Company E 10%

This is a simplified educational example and does not represent a real ETF.

Why are the weights different?

The percentage that each investment represents in a fund is often called its weight or allocation. ETFs can determine these weights in different ways depending on the fund's strategy. Some ETFs may give larger weights to larger companies, while others may use equal weights or follow different weighting methods.

Can the holdings change?

Yes. The investments held by an ETF and their weights can change over time as the fund follows its investment strategy, tracks an index, or adjusts its portfolio.

Comparison

ETF vs. individual stock

ETFs and individual stocks can both trade on stock exchanges, but they represent different types of ownership and exposure.

ETF Individual Stock

Represents An interest in an investment fund and its portfolio Ownership in one company

Holdings Can contain multiple investments One company

Exposure Depends on the assets held by the fund Depends on the individual company

Trading Bought and sold on an exchange Bought and sold on an exchange

Important to know

More holdings does not always mean more diversification

An ETF may hold many investments while still being concentrated in a particular industry, country, asset type, or investment strategy. What the fund holds can matter as much as the number of holdings. ETFs can also differ significantly in their holdings, strategies, costs, risks, and performance. Understanding what a fund holds and how it is designed is an important part of understanding the ETF.

Key takeaway

What should you remember?

An ETF is an investment fund whose shares can be bought and sold on a stock exchange. A single ETF can hold multiple investments in different proportions, providing exposure to many assets through one fund. Its holdings may generate income and may change over time. ETFs can also differ greatly in their strategies, costs, risks, and level of diversification, so understanding what a fund actually holds is important.

Continue learning

Continue learning about investing

Review the investing fundamentals or continue learning how diversification can help manage portfolio risk.

Investing Basics

Review the fundamental concepts of investing, including assets, returns, risk, and portfolios.

Diversification

Learn how spreading money across different investments can help manage portfolio risk.

ETFs: How They Work