An exchange-traded fund (ETF) is a financial instrument which tracks an index. The main difference to mutual funds is the fact that ETFs are, as their name implies, not bought by an investor directly from the issuing firm, but are bought and sold on an exchange, where their price is updated frequently to conform to the actual demand and supply.
Index funds, as ETFs are often called, are typically passively managed. This means that the fund’s managers are not engaged in selective stock picking, but are merely trying to replicate a specific index by holding the applicable securities. There are different ways to achieve this goal, however: The most natural option would be a full replication, which would mean that the fund owns all securities represented in the index in the same proportion as their weight in the index demands. As this option is sometimes not possible -either due to the size of the index, which may incorporate several hundred securities, or due to the illiquidity of the underlying market as for example with a global uranium ETF- an ETF may engage in “selective optimization” by holding only a subset of the index securities while trying to replicate the true behavior of the index.
The issuing firm of an ETF does not directly trade their product on an exchange. Rather, the firm will create large packages of the fund’s shares, the so-called “creation units”, and sell them directly to authorized participants of the primary market for the ETF. These authorized participants are usually large institutional investors which will then in turn sell the shares from the creation units they bought on the secondary market, the exchange.
Individual investors buy and sell their ETF shares from each other and from the participants of the primary market. The participation of the primary investors on the exchange trade has one main goal: to provide liquidity in times when the individual investors, acting through their retail brokers, either sell or buy as a majority as has for example happened often with the Japanese Nikkei ETF.
The overall system described above makes exchange-traded funds special financial instruments which are therefore able to achieve goals that could not be met before their existence, explaining their large and growing popularity in the investment community.