An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the day on stock exchanges whereas mutual funds are bought and sold from the issuer based on their price at day's end. An ETF holds assets such as stocks, bonds, currencies, futures contracts, and/or commodities such as gold bars, and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value,although deviations can occasionally occur. Most ETFs are index funds: that is, they hold the same securities in the same proportions as a certain stock market index or bond market index. The most popular ETFs in the U.S. replicate the S&P 500, the total market index, the NASDAQ-100 index, the price of gold, the "growth" stocks in the Russell 1000 Index, or the index of the largest technology companies.  With the exception of non-transparent actively managed ETFs, in most cases, the list of stocks that each ETF owns, as well as their weightings, is posted daily on the website of the issuer. The largest ETFs have annual fees of 0.03% of the amount invested, or even lower, although specialty ETFs can have annual fees well in excess of 1% of the amount invested. These fees are paid to the ETF issuer out of dividends received from the underlying holdings or from selling assets.

An ETF divides ownership of itself into shares that are held by shareholders. The details of the structure (such as a corporation or trust) will vary by country, and even within one country there may be multiple possible structures. The shareholders indirectly own the assets of the fund, and they will typically get annual reports. Shareholders are entitled to a share of the profits, such as interest or dividends, and they would be entitled to any residual value if the fund undergoes liquidation.

ETFs may be attractive as investments because of their low costs, tax efficiency, and tradability.

As of August 2021, $9 trillion was invested in ETFs globally, including $6.6 trillion invested in the U.S.

In the U.S., the largest ETF issuers are BlackRock iShares with a 35% market share, The Vanguard Group with a 28% market share, State Street Global Advisors with a 14% market share, Invesco with a 5% market share, and Charles Schwab Corporation with a 4% market share.

Closed-end funds are not considered to be ETFs, even though they are funds and are traded on an exchange. Exchange-traded notes are debt instruments that are not exchange-traded funds.

Uses and Benefits
Among the advantages of ETFs are the following, some of which derive from the status of most ETFs as index funds:

COSTS

Since most ETFs are index funds, they incur low expense ratios because they are not actively managed. An index fund is much simpler to run, since it does not require security selection, and can be done largely by computer.

Unlike mutual funds, ETFs do not have to buy and sell securities to accommodate shareholder purchases and redemptions. And thus, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. ETFs typically have extremely low marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.

Over the long term, these cost differences can compound into a noticeable difference. However, some mutual funds are index funds as well and also have very low expense ratios, and some specialty ETFs have high expense ratios.

To the extent a stockbroker charges brokerage commissions, because ETFs trade on stock exchanges, each transaction may be subject to a brokerage commission. In addition, sales of ETFs in the United States are subject to the Section 31 Transaction Fee payable to the SEC, currently 0.00221% of the net proceeds from the transaction. Mutual funds are not subject to commissions and SEC fees; however, some mutual funds charge front-end or back-end loads, while ETFs do not have loads at all.

TAXATIONS

The examples and perspective in this article may not represent a worldwide view of the subject. (August 2021)
ETFs are structured for tax efficiency and can be more attractive tax-wise than mutual funds.

Unless the investment is sold, ETFs generally generate no capital gains taxes, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency compared to mutual funds is further enhanced because ETFs do not have to sell securities to meet investor redemptions.

In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must "distribute" the capital gains to its shareholders and the shareholders must pay capital gains taxes on the amount of the gain (unless such investment is held in an individual retirement account), even if the distribution is reinvested. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. In contrast, ETFs are not redeemed by investors; any investor who wants to liquidate generally would sell the ETF shares on the secondary market, so investors generally only realize capital gains when they sell their own shares for a gain.[18]

In most cases, ETFs are more tax-efficient than mutual funds in the same asset classes or categories.

An exception is some ETFs offered by The Vanguard Group, which are simply a different share class of their mutual funds. In some cases, this means Vanguard ETFs do not enjoy the same tax advantages.

In other cases, Vanguard uses the ETF structure to let the entire fund defer capital gains, benefiting both the ETF holders and mutual fund holders.

In the United Kingdom, ETFs can be shielded from capital gains tax by investing in them via an Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP), in the same manner as many other shares. Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.

The tax efficiency of ETFs are of no relevance for investors using tax-deferred accounts or investors who are tax-exempt, such as certain nonprofit organizations.

TRADING

ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. Also unlike mutual funds, since ETFs are publicly traded securities, investors can execute the same types of trades that they can with a stock, such as limit orders, which allow investors to specify the price points at which they are willing to trade, stop-loss orders, margin buying, hedging strategies, and there is no minimum investment requirement. Because ETFs can be cheaply acquired, held, and disposed of, some investors buy and hold ETFs for asset allocation purposes, while other investors trade ETF shares frequently to hedge risk or implement market timing investment strategies.

Options, including put options and call options, can be written or purchased on most ETFs – which is not possible with mutual funds. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on call options written against them. There are also ETFs that use the covered call strategy to reduce volatility and simplify the covered call process.

Market exposure and diversification

If they track a broad index, ETFs can provide some level of diversification. Like many mutual funds, ETFs provide an economical way to rebalance portfolio allocations and to invest cash quickly. An index ETF inherently provides diversification across an entire index, which can include broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.

Transparency

The SEC generally requires ETFs to be transparent and issuers generally are required to publish the composition of the ETF portfolios daily on their websites. However, the SEC does allow certain actively managed ETFs to be non-transparent - i.e. they do not have to disclose exactly what they own.

ETFs are priced continuously throughout the trading day and therefore have price transparency.

RISKS

TRACKING ERROR

The ETF tracking error is the difference between the returns of the ETF and its reference index or asset. A non-zero tracking error therefore represents a failure to replicate the reference as stated in the ETF prospectus. The tracking error is computed based on the prevailing price of the ETF and its reference. It is different from the premium/discount which is the difference between the ETF's NAV (updated only once a day) and its market price. Tracking errors are more significant when the ETF provider uses strategies other than full replication of the underlying index. Some of the most liquid equity ETFs tend to have better tracking performance because the underlying index is also sufficiently liquid, allowing for full replication. In contrast, some ETFs, such as commodities ETFs and their leveraged ETFs, do not necessarily employ full replication because the physical assets cannot be stored easily or used to create a leveraged exposure, or the reference asset or index is illiquid. Futures-based ETFs may also suffer from negative roll yields, as seen in the VIX futures market.

While tracking errors are generally non-existent for the most popular ETFs, they have existed during periods of market turbulence such as in late 2008 and 2009 and during flash crashes, particularly for ETFs that invest in foreign or emerging-market stocks, future-contracts based commodity indices, and high-yield debt. In November 2008, during a period of market turbulence, some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened. Per Morgan Stanley, in 2009, ETFs missed their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008.

LIQUIDITY RISK

ETFs have a wide range of liquidity. The most popular ETFs (such as those tracking the S&P 500) are constantly traded, with tens of millions of shares per day changing hands, while others trade in much lower numbers. There are many ETFs that do not trade very often, and thus might be difficult to sell compared to more liquid ETFs. The most active ETFs are very liquid, with high regular trading volume and tight bid-ask spreads (the gap between buyer and seller's prices), and the price thus fluctuates throughout the day. This is in contrast with mutual funds, where all purchases or sales on a given day are executed at the same price at the end of the trading day.

New regulations to force ETFs to be able to manage systemic stresses were put in place following the 2010 flash crash, when prices of ETFs and other stocks and options became volatile, with trading markets spiking and bids falling as low as a penny a share in what the Commodity Futures Trading Commission (CFTC) investigation described as one of the most turbulent periods in the history of financial markets.

These regulations proved to be inadequate to protect investors in the August 24, 2015, flash crash,"when the price of many ETFs appeared to come unhinged from their underlying value." ETFs were consequently put under even greater scrutiny by regulators and investors. Analysts at Morningstar, Inc. claimed in December 2015 that "ETFs are a 'digital-age technology' governed by 'Depression-era legislation".

RISK OF SYNTHETIC ETFs

Synthetic ETFs, which do not own securities but track indexes using derivatives and swaps, have raised concern due to lack of transparency in products and increasing complexity; conflicts of interest; and lack of regulatory compliance.

COUNTERPARTY RISK

A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty. A potential hazard is that the investment bank offering the ETF might post its own collateral, and that collateral could be of dubious quality. Furthermore, the investment bank could use its own trading desk as counterparty. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities Directive 2009 (UCITS).

Counterparty risk is also present where the ETF engages in securities lending or total return swaps.

EFFECT ON PRICE STABILITY

Purchases and sales of commodities by ETFs can significantly affect the price of such commodities.

Per the International Monetary Fund, "Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period."

Some critics claim that ETFs can be, and have been, used to manipulate market prices, such as in conjunction with short selling that contributed to the United States bear market of 2007–2009.

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