Investor Bulletin: 

Exchange-Traded Funds (ETFs)

The SEC’s Office of Investor Education and Advocacy 

is issuing this Investor Bulletin to educate investors 

about exchange-traded funds (“ETFs”).

This Investor Bulletin discusses only ETFs that are 

registered as open-end investment companies or unit 

investment trusts under the Investment Company 

Act of 1940 (the “1940 Act”). It does not address 

other types of exchange-traded products that are not

registered under the 1940 Act, such as exchangetraded commodity funds or exchange-traded notes.

The following information is general in nature and is 

not intended to address the specifics of your financial 

situation. When considering an investment, make sure 

you understand the particular investment product fully 

before making an investment decision.

What is an ETF?

ETFs are a type of exchange-traded investment 

product that must register with the SEC under the 

1940 Act as either an open-end investment company 

(generally known as “funds”) or a unit investment 

trust.

Since the first domestically offered ETF was created 

in the 1990s, ETFs have become increasingly popular 

as investment vehicles for both retail and institutional 

investors. Like mutual funds, ETFs offer investors 

a way to pool their money in a fund that makes 

investments in stocks, bonds, or other assets and, in 

return, to receive an interest in that investment pool. 

Unlike mutual funds, however, ETF shares are traded 

on a national stock exchange and at market prices 

that may or may not be the same as the net asset value 

(“NAV”) of the shares, that is, the value of the ETF’s 

assets minus its liabilities divided by the number of 

shares outstanding.

Initially, ETFs were all designed to track the 

performance of specific U.S. equity indexes; those 

types of index-based ETFs continue to be the 

predominant type of ETF offered and sold in the 

United States. Newer ETFs, however, also seek to 

track indexes of fixed-income instruments and foreign 

securities. In addition, newer ETFs include ETFs 

that are actively managed - that is, they do not merely 

seek to passively track an index; instead, they seek 

to achieve a specified investment objective using an 

active investment strategy.

Certain ETFs can be relatively easy to understand. 

Other ETFs may have unusual investment objectives 

or use complex investment strategies that may be 

more difficult to understand and fit into an investor’s 

investment portfolio. For example, “leveraged ETFs” 

seek to achieve performance equal to a multiple of 

an index after fees and expenses. These ETFs seek to 

achieve their investment objective on a daily basis only, 

potentially making them unsuitable for long-term 

investors.

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Things to Consider before Investing in 

ETFs

ETFs are not mutual funds. Generally, ETFs combine 

features of a mutual fund, which can be purchased or 

redeemed at the end of each trading day at its NAV 

per share, with the intraday trading feature of a closedend fund, whose shares trade throughout the trading 

day at market prices. Intraday trading is described 

in greater detail below in the section on NAV and 

Intraday Value.

Unlike with mutual fund shares, retail investors 

can only purchase and sell ETF shares in market 

transactions. That is, unlike mutual funds, ETFs do 

not sell individual shares directly to, or redeem their 

individual shares directly from, retail investors. Instead, 

ETF sponsors enter into contractual relationships 

with one or more financial institutions known as 

“Authorized Participants.” Authorized Participants 

typically are large broker-dealers. Only Authorized 

Participants are permitted to purchase and redeem 

shares directly from the ETF, and they can do so only 

in large aggregations or blocks (e.g., 50,000 ETF 

shares) commonly called “Creation Units.”

To purchase shares from an ETF, an Authorized 

Participant assembles and deposits a designated basket 

of securities and cash with the fund in exchange for 

which it receives ETF shares. Once the Authorized 

Participant receives the ETF shares, the Authorized 

Participant is free to sell the ETF shares in the 

secondary market to individual investors, institutions, 

or market makers in the ETF.

The redemption process is the reverse of the creation 

process. An Authorized Participant buys a large 

block of ETF shares on the open market and delivers 

those shares to the fund. In return, the Authorized 

Participant receives a pre-defined basket of individual 

securities, or the cash equivalent.

Other investors purchase and sell ETF shares in market 

transactions at market prices. An ETF’s market price 

typically will be more or less than the fund’s NAV 

per share. This is because the ETF’s market price 

fluctuates during the trading day as a result of a variety 

of factors, including the underlying prices of the 

ETF’s assets and the demand for the ETF, while the 

ETF’s NAV is the value of the ETF’s assets minus its 

liabilities, as calculated by the ETF at the end of each 

business day.  An ETF’s market price is generally kept 

close to the ETF’s end-of-day NAV because of the 

arbitrage function inherent to the structure of the ETF. 

This is described in greater detail below in the section 

on Arbitrage.

Some Differences between ETFs and Mutual 

Funds

Some differences between ETFs and mutual funds 

include:

Because of differences in distribution and often 

lower transaction costs, total operating expense 

ratios for ETFs often have been historically less 

than those for corresponding mutual funds.

Many ETFs will disclose to the public their 

holdings every day, in addition to the quarterly 

disclosure required for all mutual funds.

ETFs can be more tax efficient than mutual funds 

because ETF shares generally are redeemable 

“in-kind.” This means that an ETF may deliver 

specified portfolio securities to Authorized 

Participants who are redeeming Creation Units 

instead of selling portfolio securities to meet 

redemption demands, which could otherwise 

result in taxable gains to the ETF. Typically, 

such taxable gains (if not otherwise offset by 

the ETF) would be passed through to the retail 

investor. Very generally, the federal income tax 

consequences of investing in ETFs and mutual 

funds are comparable. However, the SEC does 

not provide tax advice, and information about 

the federal income tax consequences to the retail 

investor of specific investments is beyond the scope 

of this bulletin. For questions regarding the tax 

implications of investments in specific ETFs and 

their consequences with respect to your unique 

situation, please consult your tax adviser. For 

more information about the federal income tax 

consequences of registered investment companies 

generally, please see our publication entitled 

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“Mutual Funds: A Guide for Investors,” also 

available at http://www.sec.gov/investor/pubs/

sec-guide-to-mutual-funds.pdf.

Certain Regulatory Requirements

Regulatory requirements include:

As investment companies, ETFs are subject 

to the regulatory requirements of the federal 

securities laws as well as certain exemptions that 

are necessary for ETFs to operate under those 

laws. Together, the federal securities laws and the 

relevant exemptions apply requirements that are 

designed to protect investors from various risks 

and conflicts associated with investing in ETFs.

For example, ETFs, like mutual funds, are subject 

to statutory limitations on their use of leverage and 

transactions with affiliates. ETFs also are subject 

to specific reporting requirements and disclosure 

obligations relating to investment objectives, 

risks, expenses, and other information in their 

registration statements and periodic reports.

In addition, ETFs are subject to oversight by 

boards of directors.

NAV and Intraday Value

An ETF (like a mutual fund) must calculate its NAV 

(the value of all its assets minus all its liabilities) every 

business day, which is done typically at the close of the 

New York Stock Exchange.

Approximately every 15 seconds throughout the 

business day, an ETF’s estimated NAV is calculated 

and distributed through quote services. This estimated 

NAV (called the IIV – for intraday indicative value – 

or IOPV – for intraday operative value – depending 

on the exchange on which the ETF lists) is unique to 

ETFs and is based on the estimated value of the ETF’s 

holdings (minus its liabilities) throughout the trading 

day.

You can find an ETF’s intraday value on various 

financial services websites, many of which are familiar 

to the general public. Often an ETF’s intraday value 

may be found by searching the ETF’s ticker symbol 

followed by “.IV”; however this will vary depending 

on the service used. You should check with the 

financial service to find out how it makes an ETF’s 

intraday value available.

Premiums and Discounts

For a variety of reasons, an ETF’s market price may 

trade at a premium or a discount to its underlying 

value. When an Authorized Participant identifies 

that an ETF’s shares are trading at either a premium 

or discount to their estimated net asset value, it may 

engage in trading strategies that are expected to result 

in the market price of an ETF’s shares moving back 

in line with its underlying value. As noted below in 

more detail, these actions by Authorized Participants, 

commonly described as “arbitrage opportunities,” 

are designed to keep the market-determined price 

of an ETF’s shares close to its underlying value. The 

premiums and discounts for specific ETFs may vary 

over time. Information about an ETF’s historical 

premiums and discounts can be found either in the 

ETF’s full prospectus or on its website.

Arbitrage

Arbitrage is the practice of taking advantage of a 

price differential between two or more markets. An 

arbitrage opportunity is inherent in the ETF structure 

because the ETF’s intraday market price fluctuates 

during the trading day. Due to this fluctuation, 

the ETF’s intraday market price may not equal the 

ETF’s end-of-day NAV. Authorized Participants can 

arbitrage this difference (and make a profit) because 

they can trade directly with the ETF at NAV as well 

as on the market. The expected result of the arbitrage 

activity is that the market value of the ETF moves 

back in line with the ETF’s NAV per share and 

investors are able to buy ETF shares on an exchange at 

a price that is close to the ETF’s NAV per share.

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irrespective of the size of the company. Although these 

two benchmarks may seem similar, they provide very 

different returns.

Actively Managed ETFs

Actively managed ETFs are not based on an index. 

Instead, they seek to achieve a stated investment 

objective by investing in a portfolio of stocks, bonds, 

and other assets. Unlike with an index-based ETF, an 

adviser of an actively managed ETF may actively buy 

or sell components in the portfolio on a daily basis 

without regard to conformity with an index.

Actively managed ETFs are required to publish their 

holdings daily. Because there is no index that can serve 

as a point of reference for an actively managed fund’s 

holdings, publishing the specific holdings allows the 

arbitrage mechanism to function. As explained above 

in the section on Arbitrage, this arbitrage mechanism 

generally keeps the market price of the ETF shares 

close to their NAV.

Final words

Before investing in an ETF, you should read both its 

summary prospectus and its full prospectus, which 

provide detailed information on the ETF’s investment 

objective, principal investment strategies, risks, costs, 

and historical performance (if any). The SEC’s 

EDGAR system, as well as Internet search engines, can 

help you locate a specific ETF prospectus. You can 

also find prospectuses on the websites of the financial 

firms that sponsor a particular ETF, as well as through 

your broker.

Be sure to do your research before purchasing an ETF. 

Before purchasing an ETF, you may wish to think 

about:

How the ETF achieves its stated objectives and 

whether those objectives are consistent with your 

goals.

Whether the risks associated with a particular ETF 

are within your tolerance for risk.

Types of ETFs

Index-Based ETFs

Most ETFs trading in the marketplace are index-based 

ETFs. These ETFs seek to track a securities index 

like the S&P 500 stock index and generally invest 

primarily in the component securities of the index. 

For example, the SPDR, or “spider” ETF, which seeks 

to track the S&P 500 stock index, invests in most or 

all of the equity securities contained in the S&P 500 

stock index. Some, but not all, ETFs may post their 

holdings on their websites on a daily basis.

Increasingly, ETFs are based on indexes that are 

designed to track specific market sectors. Thus, an 

ETF may be based on an index specifically designed 

to meet the ETF sponsor’s customers’ interests. 

Generally, although some information about the 

index (including, for some, the methodology used 

to determine what securities will be included in the 

index) is available, the specific component securities 

making up the index may or may not be.

Leveraged, inverse, and inverse leveraged ETFs may be 

considered by some to be index-based ETFs because 

they seek to deliver daily returns that are multiples (or 

inverse multiples) of the performance of the index or 

benchmark they track. For more detailed information 

regarding these types of ETFs, please see our Investor 

Alert on Leveraged and Inverse ETFs: Specialized 

Products with Extra Risk for Buy-and-Hold Investors, 

also available at http://www.sec.gov/investor/pubs/

leveragedetfs-alert.htm.

In addition, like index-based mutual funds, ETFs 

with seemingly similar benchmarks can actually 

be quite different and can deliver very different 

returns. For example, the S&P 500 is capitalization 

weighted, meaning the larger companies make up a 

much higher percentage of the index than the smaller 

companies. However, some ETFs will track an S&P 

500-styled index that is equal-weighted, meaning all 

the companies have equal representation on the index, 

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The amount of brokerage commissions you may 

pay when buying and selling ETF shares.

The other costs of owning an ETF, such as annual 

operating fees and expenses, and to what extent 

those fees have historically affected, and may affect, 

the ETF’s performance.

Whether your investment needs are better served 

by investing in an ETF or in a corresponding 

mutual fund.

Do not invest in something that you do not 

understand. If you cannot explain the investment 

opportunity in a few words and in an understandable 

way, you may need to reconsider the potential 

investment.

Finally, you may wish to consider seeking the advice 

of an investment professional. If you do, be sure to 

work with someone who understands your investment 

objectives and tolerance for risk. Your investment 

professional should understand complex products and 

be able to explain to your satisfaction whether or how 

they fit with your objectives.

Related Items

SEC Fast Answers, Exchange-Traded Funds

FINRA Regulatory Notice 09-31

FINRA Non-Traditional ETFs FAQ

NYSE Informed Investor, What You Should 

Know About Exchange Traded Funds

The Office of Investor Education and Advocacy 

has provided this information as a service to 

investors. It is neither a legal interpretation nor 

a statement of SEC policy. If you have questions 

concerning the meaning or application of a 

particular law or rule, please consult with an 

attorney who specializes in securities law.

Investor Assistance (800) 732-0330 August 2012

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