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An exchange-traded fund (ETF) is a pooled investment vehicle that holds a basket of assets, typically stocks or bonds, and trades on a stock exchange throughout the day like an individual share. You buy or sell ETF shares at market prices that fluctuate in real time. The underlying portfolio usually tracks an index, but actively managed ETFs with discretionary holdings have grown rapidly since the SEC updated its rules in 2019. Global ETF assets under management surpassed $14 trillion in 2024, with U.S.-listed funds accounting for roughly two-thirds of that total.
ETFs combine the diversification of a mutual fund with the trading flexibility of a stock.
An ETF's market price closely tracks its net asset value through a creation and redemption mechanism operated by authorized participants, which are large financial institutions. When the ETF's market price trades above its net asset value, authorized participants create new ETF shares by delivering the underlying basket to the fund and receive ETF shares in return, which they then sell in the market. This arbitrage drives the price back toward net asset value.
The same process works in reverse. When the ETF trades below net asset value, authorized participants buy ETF shares on the market and redeem them to the fund in exchange for the underlying securities, collecting the spread. This continuous arbitrage keeps ETF market prices tightly aligned with the value of the underlying holdings throughout the trading day.
Most ETFs by assets under management track an index passively. They buy the same securities in the same proportions as the index they follow, hold them until the index changes, and minimize turnover to reduce tax consequences. The S&P 500 SPDR ETF (SPY), launched in January 1993 as the first U.S. ETF, remains among the most heavily traded securities in the world with daily volume often exceeding 60 million shares.
Passive ETFs charge very low fees because they do not require active management. The Vanguard S&P 500 ETF (VOO) carries an expense ratio of 0.03%, meaning annual costs of $3 on every $10,000 invested. These low costs compound into significant advantages over higher-cost alternatives over multi-decade holding periods.
Active ETFs hold portfolios selected by a portfolio manager rather than dictated by an index. ARK Investment Management's Innovation ETF popularized the active ETF structure in the retail market. Active ETFs gained regulatory clarity from the SEC's Exemptive Order framework updated in 2019, which standardized disclosure requirements and eliminated the need for individual fund exemptions. By early 2025, actively managed ETFs held over $1 trillion in assets in the United States alone.
| ETF | Mutual Fund | |
|---|---|---|
| Trading | Intraday on exchange at market price | Once daily at net asset value after market close |
| Minimum Investment | Price of one share; fractional shares available at many brokers | Often $500 to $3,000 minimum initial investment |
| Tax Efficiency | High; in-kind redemptions minimize capital gains distributions | Lower; redemptions may trigger taxable capital gains for all holders |
| Expense Ratio (passive) | As low as 0.03% | Often 0.50% to 1.50% for actively managed funds |
ETFs are structurally more tax-efficient than mutual funds because of how they handle redemptions. When mutual fund investors redeem, the fund must sell securities and may distribute capital gains to all remaining shareholders, who owe tax even if they never sold their own shares. ETFs redeem through in-kind transfers of the underlying securities to authorized participants. Because no securities are sold in a cash transaction, no capital gains are realized inside the fund, and shareholders only pay capital gains tax when they sell their own ETF shares.
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