ETF distributors only buy or sell ETFs directly from or to authorized participants, which are large broker-dealers with whom they have entered into agreements—and then, only in creation units, which are large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but they usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market.
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be ETFs, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.
ETFs offer both tax efficiency as well as lower transaction and management costs. More than US$2 trillion were invested in ETFs in the United States between when they were introduced in 1993 and 2015. By the end of 2015, ETFs offered "1,800 different products, covering almost every conceivable market sector, niche and trading strategy".
An ETF is a type of fund. It owns assets (bonds, stocks, gold bars, etc.) and 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 an annual report. Shareholders are entitled to a share of the profits, such as interest or dividends, and they may get a residual value in case the fund is liquidated. Their ownership interest in the fund can easily be bought and sold.
ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a stock exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (NAV). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks (such as 50,000 shares), called creation units. Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.
If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.