Introduction to ETFs
An exchange-traded fund holds a basket of assets and issues shares that trade on an exchange. Buying one share buys proportional exposure to everything the fund holds.
The interesting question is not what an ETF is, but why its price stays close to the value of its holdings when nothing forces it to. The answer is an arbitrage mechanism, and it makes ETFs one of the most elegantly designed instruments in markets.
Against mutual funds
A mutual fund is priced once daily at net asset value. You submit an order and receive the closing valuation, whatever it turns out to be.
An ETF trades continuously at whatever the market bears. That gives intraday execution, the ability to use limit orders, and the ability to short or borrow it.
The structural advantage is tax efficiency in some jurisdictions, arising from in-kind creation and redemption: the fund can meet redemptions by handing over securities rather than selling them, which does not realise gains.
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