Exchange traded fund (ETF)

A fund that pools money, holds a defined basket of assets fixed by its published objective, and issues its own shares against that pool. Those shares are listed, so they change hands throughout the session at whatever price buyers and sellers agree, which is what separates an ETF from an ordinary fund dealt once a day at its net asset value.

The traded price stays close to the value of the holdings through a mechanism rather than a promise. Large institutions authorised by the fund can create new fund shares by delivering the underlying basket, and redeem them by handing fund shares back for the basket. When the traded price runs above the value of the holdings there is a profit in creating and selling, and when it runs below there is a profit in buying and redeeming, so the two are pulled together continuously. Where the mechanism works less well, in a fund holding assets that are themselves hard to deal, a premium or a discount can persist.

Replication method is the detail most often skipped. A physical fund holds the constituents, either all of them or a representative sample. A synthetic fund holds collateral and enters a swap with a bank that pays the index return, which removes sampling error and introduces exposure to that bank instead. Either way the fund's own running costs are deducted from its assets continuously, so a fund lags the index it follows by approximately those costs before any other effect, and the gap over a stated period is its tracking difference. Leveraged and inverse products are a separate case: they reset their exposure daily, so over any period longer than a day their return is not the index return multiplied by a constant.

A contract for difference written on an ETF references the listed price of the fund's shares and settles in cash. No fund share is held, nothing is registered, the fund does not know the contract exists, and distributions reach the contract only as an adjustment applied when the fund goes ex-dividend.