🎯 In 30 seconds: An index fund holds every stock in an index so you own the whole basket in one purchase. An ETF (exchange-traded fund) is a fund that trades on an exchange all day like a stock. Many ETFs are index funds, but not all. Large firms called authorized participants create and redeem ETF shares, which keeps the price close to the value of the holdings. Costs are mostly the yearly expense ratio, and small differences add up over decades. Leveraged and inverse ETFs are built for one-day bets: over longer periods they can lose money even when you get the direction right.
Index funds and ETFs: the basic idea
A fund pools money from many investors and buys a portfolio of securities. Each investor owns a slice of the whole portfolio.
An index fund tries to match an index, such as the S&P 500, by holding the same stocks in the same proportions. It does not try to pick winners. Because there is little research to pay for, costs are usually low. See Market indexes for how the indexes themselves are built.
An ETF (exchange-traded fund) is a fund whose shares trade on a stock exchange. You buy and sell it through a broker during market hours, at whatever price the market offers, exactly like a stock. A traditional mutual fund is different: you buy from and sell back to the fund itself, once a day, at the closing net asset value (NAV), which is the value of the fund's holdings per share.
Index funds can be ETFs or mutual funds. ETFs can track an index or be actively managed. The two ideas overlap but are not the same.
How ETFs work behind the scenes
You never deal with the ETF company directly. You buy shares from another investor on the exchange. So how do new ETF shares come into existence when demand grows?
The fund signs contracts with a few large financial firms called authorized participants (APs), typically big broker-dealers. Only APs deal with the fund directly, and only in large blocks called creation units. The SEC gives 50,000 shares as an example of a block size.
- Creation: the AP delivers a basket of stocks that mirrors the fund's portfolio, and receives new ETF shares in return. It can then sell those shares on the exchange.
- Redemption: the AP buys ETF shares on the exchange, hands them to the fund, and receives the underlying stocks or cash.
This is what keeps the ETF's market price close to its NAV. If the ETF trades above the value of its holdings (a premium), an AP can buy the cheaper stocks, create ETF shares and sell them at the higher price. That selling pushes the ETF price down. If the ETF trades below NAV (a discount), the AP does the reverse. The SEC calls this the arbitrage function built into the ETF structure.
The arbitrage works well when the underlying assets trade easily, like large US stocks. It works less well when they do not, such as some bond markets in a panic or foreign markets that are closed while the ETF trades in New York. Then premiums and discounts can get bigger.
What ETFs cost: the expense ratio and more
The expense ratio is the fund's yearly operating cost as a percentage of your investment. It is taken out of the fund's assets daily, so you never see a bill. It shows up as a slightly lower return.
| $10,000 in a fund with a 0.03% expense ratio | $3 a year |
| $10,000 in a fund with a 0.50% expense ratio | $50 a year |
| $10,000 in a fund with a 1.00% expense ratio | $100 a year |
Those numbers look small. Over long periods they compound. Assume (hypothetically) that the investments earn 7% a year before fees, for 30 years:
| Expense ratio | Return after fees | $10,000 after 30 years |
|---|---|---|
| 0.03% | 6.97% | $75,485 |
| 0.50% | 6.50% | $66,144 |
| 1.00% | 6.00% | $57,435 |
The gap between the cheapest and most expensive fund is about $18,000 on a $10,000 start, for the same underlying investments. That is why cost is one of the first things to check.
Other costs to watch:
- The bid-ask spread. Large, popular ETFs often trade with a one-cent spread. Small, niche ETFs can have spreads of 0.2% or more, which you pay every time you trade. See What trading really costs.
- Premium or discount. Buying at a premium means paying more than the holdings are worth.
- Tracking difference. The gap between the fund's return and its index's return over time, from fees, cash holdings and trading costs.
Broad, sector and thematic ETFs
Broad market ETFs track indexes like the S&P 500 or the total US stock market. They hold hundreds or thousands of companies and are the usual core of a long-term portfolio. See A plan for a young person.
Sector ETFs hold one sector, such as technology, health care or energy. Traders use them to bet on one part of the economy without picking individual companies. They are less diversified, so they swing more. Sectors and the business cycle explains the 11 sectors.
Thematic ETFs follow a story: robotics, clean energy, cybersecurity. They often launch when a theme is already popular and prices are high, carry higher expense ratios, and hold fewer stocks. Read the holdings list before you buy one; the fund's name may not match what it owns. Most ETFs publish their holdings every day.
Leveraged and inverse ETFs: built for one day
A leveraged ETF aims to deliver a multiple, such as 2x or 3x, of an index's daily return. An inverse ETF aims to deliver the opposite of the daily return (-1x), and a leveraged inverse ETF aims for -2x or -3x. They use derivatives such as swaps and futures to do this.
The key word is daily. These funds reset their exposure every day. Over longer periods, compounding makes their results drift away from the multiple you might expect. The SEC gives this hypothetical two-day example:
| Index | 2x leveraged ETF | |
|---|---|---|
| Start | 1,000 | $1,000 |
| Day 1: index -10% | 900 | $800 (-20%) |
| Day 2: index +10% | 990 | $960 (+20%) |
| Two-day result | -1% | -4% |
The fund did exactly what it promised each day. Over two days it lost four times what the index lost, not twice. Now stretch that over a choppy month:
The index ends down 2.5%. The 2x fund ends down 9.6%. The -2x fund, which was supposed to profit from a falling index, also ends down 9.6%. The math: each up-and-down pair multiplies the index by 1.05 x 0.95 = 0.9975, but the 2x fund by 1.10 x 0.90 = 0.99. The bigger the daily swings, the faster this volatility decay eats into the fund.
In a strong, steady trend, a leveraged fund can beat its multiple. In a choppy market, it loses. Since you cannot know in advance which you will get, holding these funds for weeks or months is a different bet from the one their name describes. The SEC's bulletin gives real cases: over four months, one index gained 2% while a 2x fund on it fell 6%, and another index gained about 8% while a 3x fund fell 53%.
The SEC has also warned about single-stock ETFs that apply leverage or inverse exposure to one company, which removes diversification and adds even more volatility. Leverage everywhere compares these funds with margin, options and futures.
ETNs: similar ticker, different risk
An exchange-traded note (ETN) trades on an exchange like an ETF and often tracks an index, but it is a different thing. An ETN is an unsecured debt note issued by a bank or other financial institution. It promises to pay the index return, minus fees, but it does not own a portfolio of assets.
That means you take on the issuer's credit risk. If the issuer gets into financial trouble, the ETN can lose value or become worthless even if the index did fine. The SEC's ETN bulletin warns that ETNs are complex and can result in the loss of your entire investment. Check whether a product's documents say "fund" or "note" before you buy it.
Try it
Use the index dashboard to see how the major indexes moved this month. Then, in the paper portfolio, put half of a practice balance into a broad index ETF and keep notes on any sector or thematic ETF that interests you. Finally, redo the leveraged ETF math with a spreadsheet: start at 100, alternate +3% and -3% for 50 days, and compare the index, a 2x fund and a 3x fund. Then try a steady +1% a day for 20 days and see how the result flips.
- What keeps an ETF’s market price close to the value of its holdings (NAV)? Answer: Authorized participants create new ETF shares when it trades at a premium and redeem them when it trades at a discount. The SEC calls this the arbitrage function.
- What does $10,000 in a fund with a 0.50% expense ratio cost you a year? Answer: $50.
- An index falls 10% one day and rises 10% the next. What happens to $1,000 in a 2x leveraged ETF? Answer: It goes to $800, then $960: down 4%, while the index is down only 1%.
- How is an ETN different from an ETF? Answer: An ETN is an unsecured debt note from a bank or other institution. It owns no portfolio, so you take on the issuer’s credit risk.