An exchange traded fund (ETF) is an investment vehicle that combines key features of traditional mutual funds and individual stocks.  Like index mutual funds, ETFs represent diversified portfolios of securities that track specific indexes.  Like stocks, they can be bought and sold (long or short) on an exchange throughout the trading day.  In addition to trading flexibility, key ETF benefits include instant diversification, tax efficiency, and transparency of cost and holdings.

While ETF’s trade on an exchange like stocks, the process by which their shares are created is significantly different.  Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite.  When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand.

Through an “in kind” transfer mechanism, APs create ETF units in the primary market by delivering a basket of securities to the fund equal to the current holdings of the ETF.  In return, they receive a large block of ETF shares (typically 50,000), which are then available for trading in the secondary market.  This creation and redemption mechanism helps keep ETF supply and demand in continual balance and provides a “hidden” layer of liquidity not evident by looking at trading volumes alone.

This process also works in reverse.  If an investor wants to sell a large block of shares of an ETF, even if there seems to be limited liquidity in the secondary market, APs can readily redeem a block of ETF shares by gathering enough shares of the ETF to form a creation unit and then exchanging the creation unit for the underlying securities.

Most ETFs are designed to track published market indexes. Index-based investing offers several benefits, including lower costs than most active management strategies and performance that seeks to track a benchmark.  In addition, index funds are broadly diversified since they typically hold all or many of the securities within the index.  This gives you “instant” diversification that can help manage portfolio risk versus holding one or just a few individual stocks.

First ever ETF appeared in United States in 1993 with the introduction of Standard & Poor’s 500 Depository Receipts (SPDRS).  Investment management companies, such as Barclays (iShares), Invesco (PowerShares), Fidelity, Vanguard, WisdomTree, and etc. have introduced more ETF’s in the last decade.  Now, there are more than 1,000 ETF’s available to the general public.