ETF (Exchange Traded Fund)

### What you are actually buying An ETF is a wrapper, not an asset. Buy SPY and you do not own the S&P 500, you own a share of a fund that holds the stocks. The fund's per-share value of those holdings is its NAV. The price you pay on the exchange is set by supply and demand, which is why the SEC's investor bulletin on ETFs says an ETF's market price will typically be more or less than its NAV. Above is a premium, below is a discount. ### The machine that keeps the price honest A handful of large broker-dealers, the Authorized Participants, can transact directly with the fund, but only in big blocks the SEC calls creation units (its bulletin uses 50,000 shares as the example), normally swapping the actual basket of underlying stocks for ETF shares rather than cash. If the ETF drifts above the value of its holdings they create and sell it. If it drifts below, they buy and redeem it. That arbitrage loop is the entire reason the ticker tracks the index. SEC Rule 6c-11 also requires the ETFs that rely on it to publish their full portfolio holdings on their website every business day before the opening of trading, so you can check exactly what you own. ### It can break On 24 August 2015 it did. The SEC's staff white paper *The Determinants of ETF Trading Pauses on August 24th, 2015* found that 302 of 1,569 ETFs, 19.2%, moved violently enough to trigger a limit up-limit down trading pause that morning, with many changing hands well away from the value of the stocks inside them. Firing a market order into a chaotic open is how you end up on the wrong side of that. ### The two costs The expense ratio, published by the issuer (State Street lists SPY's gross expense ratio at 0.0945%, Invesco lists QQQ at 0.18%), and the spread, which the SEC's bulletin calls a hidden cost because it quietly reduces your return on every round trip. Fidelity's own ETF guidance makes the point beginners miss: an ETF's average volume is not the same thing as its liquidity. What the fund holds underneath decides how tightly it really trades, which is why a niche sector or emerging-market ETF can look busy and still fill you badly. ### The trap: leveraged and inverse ETFs These reset daily, and compounding does the rest. The SEC's bulletin on them gives a real example: over four months an index gained 2 percent, while a leveraged ETF seeking twice that index's daily return fell by 6 percent, and an inverse ETF seeking twice the inverse of the daily return fell by 25 percent. They deliver what they promise over a single day and something else entirely over a month, which is why the SEC says they generally are not suitable for buy-and-hold investors. None of this changes how you read a chart. SPY and QQQ are deep, liquid instruments you can mark structure on like any other. The wrapper does not change your process. It changes what you are exposed to, and that is worth knowing before you click.