Anatomy of an ETF

At the most basic level, exchange traded funds are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. Funds can track any number of indices from the large-cap DJ Euro STOXX 50, the FTSE 100, small-cap indices, or even commodities. ETFs often look similar to an index fund, but there are some important differences.

The process of buying and selling ETFs works differently than with funds. ETFs trade like individual stocks. You can purchase them in real time at any point during the day, unlike funds, which settle only once a day. This means you can use trading features like stop losses on an ETF that you can't use on an open-end fund. There are no redemption fees on ETFs, unlike on many of their fund cousins, but investors do pay a transaction fee to their broker every time they buy or sell shares.

To a large extent, the supply and demand for ETF shares is driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios. However, a special process that allows large investors to take advantage of this price differential should, in theory, help prevent sustained discounts or premiums from opening up.

The fact that you must trade ETFs with other market participants means that an ETF will have two prices: A net asset value, which is set daily based on the ending value of its portfolio and accrued expenses--just like a traditional fund--and a share price, which is determined by the ETF's supply/demand profile in the market, just like a stock.

Many different fund companies have ETFs on the market currently, under brand names like iShares, db x-trackers, Lyxor, EasyETF, ETFS, and Xmtch. Most of them are passively managed, tracking a wide variety of broad to narrow market indices.

Funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a great percentage of the ETF universe, offering relatively inexpensive access to investments such as currencies, precious metals, or emergent industries that hitherto have been the sole province of larger institutional and wealthy investors. Recently, fund companies have also launched actively managed ETFs. These funds are not tethered to a benchmark, but continue to sport the familiar benefits of ETFs.