Module 7 · Lesson 5 of 7 · Stocks and ETFs · About 5 minutes
How ETFs Work: Creation, Redemption, NAV and Costs
On this page
Before you read: Stock Splits, Dividends and Corporate Actions Explained
What you will learn
- What an ETF holds and how its price relates to its net asset value.
- How authorized participants create and redeem shares to keep the price close to NAV.
- What the expense ratio, spread and tracking difference cost.
What is an ETF?
How can one share give you a slice of hundreds of companies?
An exchange-traded fund is a fund whose shares trade on an exchange like a stock. Most ETFs hold a basket of securities, such as the stocks in an index, bonds, or commodities through futures. Some are actively managed. Buying one share gives you a proportional slice of everything the fund holds, minus its costs.
The fund publishes its holdings, usually every day, and calculates its net asset value (NAV) once a day: the value of everything it holds, minus liabilities, divided by shares outstanding. During the day, many ETFs also have an intraday indicative value published, an estimate of NAV updated every few seconds. SEC rules do not require it, and it can be stale for funds whose holdings trade less often or in other time zones.
Try it on a chart
- Switch between SPY, QQQ and DIA at the top of the chart.
- Compare how far each moved over the same period.
Charts and quotes are TradingView's data, not ours, and may be delayed.
How does the price stay close to NAV?
If an ETF traded well above the value of what it holds, who would have a reason to step in?
ETF shares are created and redeemed in large blocks, often tens of thousands of shares, by authorized participants (APs), usually large trading firms:
- Creation. If the ETF trades above the value of its holdings, an AP can deliver the underlying basket (or cash) to the fund, receive new ETF shares, and sell them. That adds supply and pushes the price down toward NAV.
- Redemption. If the ETF trades below the value of its holdings, an AP can buy ETF shares, hand them back to the fund, and receive the basket. That removes supply and pushes the price up toward NAV.
This arbitrage usually keeps the price close to NAV for funds whose holdings trade at the same time. The gap, called a premium or discount, can widen when the holdings are hard to trade, such as some bonds in stressed markets, or when the holdings trade in a different time zone, such as an ETF of Asian stocks trading during US hours.
Creation and redemption diagram
Illustrative diagram constructed for teaching. Not real market data.
The diagram shows a fictional authorized participant delivering a basket of stocks to an ETF in exchange for new shares, and the reverse for redemption, with arrows showing how each step pulls the ETF price toward NAV. It is constructed for teaching and is not real market data.
What do ETFs cost?
Which costs show up on a statement, and which ones do not?
- Expense ratio. The annual fee, taken from fund assets day by day. A 0.20% expense ratio costs about $2 a year for every $1,000 held. You do not see a separate charge; it is reflected in the fund’s value.
- Spread. The bid-ask spread each time you buy or sell. Heavily traded ETFs often have very tight spreads; small or niche ones can be wider.
- Tracking difference. The gap between the fund’s return and its index’s return over a period. Fees, cash drag, sampling and trading costs all contribute. Tracking error is the variability of that gap.
Commissions and taxes are separate and depend on your broker, account and country.
How do ETFs differ from mutual funds and stocks?
What can you do with an ETF during the trading day that you cannot do with a mutual fund?
A traditional mutual fund is bought and sold once a day at NAV, directly with the fund. An ETF trades throughout the day at market prices, which can be a little above or below NAV. Like a stock, an ETF can be bought with limit orders, sold short, and used as the underlying for options. Unlike a single stock, its value depends on a basket, and the rules of that basket are set out in the fund’s prospectus.
What this does not tell you about ETFs
- Whether any ETF suits you. The prospectus describes its holdings, risks and costs.
- How ETFs are taxed for you. That depends on the fund’s structure, your country and your account. Ask a tax professional.
- That every ETF tracks its index closely. Funds that hold futures, use leverage or hold illiquid assets can drift further.
- Nothing here recommends buying or selling any fund.
Check yourself
- An ETF holds $200 million of assets, owes $1 million, and has 4 million shares. What is its NAV per share? Hint: (assets − liabilities) ÷ shares.
- An ETF trades above the value of its holdings. What can an authorized participant do? Hint: create and sell.
- Roughly what does a 0.10% expense ratio cost per year on $10,000? Hint: one-tenth of one percent.
Reflect on your own process
- Before writing down an ETF's cost, which documents do you check for its expense ratio and typical spread?
- How does your checklist compare an ETF's market price with its NAV, and where do you get each number?
- What would you record in your journal if a fund traded at a noticeable premium or discount to NAV?