Exchange-traded funds (ETFs) offer investors a way to pool money in a fund that invests in multiple stocks, bonds, or other combinations of financial assets. The first U.S. ETF was introduced in 1993 to track the S&P 500 index. Over the past 25 years, ETFs have become common investment vehicles to help American retail investors build financial nest eggs and to help institutional investors meet financial obligations. They are a major type of investment within a broader financial product category called exchange-traded products (ETPs), which is a catchall term for all portfolio products that trade on exchanges. Global ETP assets grew 61-fold from $79 billion in 2000 to $4.8 trillion as of March 2018. U.S. ETFs represent the majority of that market, with 1,832 ETFs totaling $3.4 trillion in assets under management ( Figure 1 ). The rapid growth in ETFs is attributable to their perceived advantages: (1) low costs and fee savings; (2) comparable or even higher investment returns relative to other comparable portfolio investment alternatives, namely mutual funds; (3) U.S. tax efficiency; (4) exchange-trading-related advantages, including additional liquidity and price transparency; and (5) portfolio hedging and diversification benefits. The report first explains how ETFs work. This section clarifies a number of technical points on ETF design, trading, and classification that are common sources of confusion. The report also discusses other key policy issues, including ETFs' relevance to financial stability considerations, the implication of the rise of passively managed funds (a category that encompasses the majority of ETFs), the higher risks often associated with nontraditional ETPs, investor protection issues, and the SEC's recent ETF rulemaking, among other topics. ETFs are often compared to mutual funds. They are both SEC-registered investment companies that pool money from many investors and invest the proceeds in a portfolio of bonds, stocks, and other securities assets. However, ETFs can be traded on exchanges, whereas mutual funds are bought or sold only by fund companies or intermediaries like financial advisors or brokers. ETFs combine common features of both mutual funds and stocks. They package a portfolio of assets like a mutual fund and can be traded on exchanges like a stock. As Figure 2 illustrates, when compared to mutual funds, ETFs provide additional trading and cost advantages. When compared to stocks, ETFs allow for the trading of a basket of assets at the same time, instead of one stock per trade, for each transaction. This characteristic allows ETFs to achieve price transparency through intraday trading for a basket of assets. ETF sponsors typically assemble a collection of securities and then divide the basket of securities into tradable shares. In terms of operational structure, unlike mutual funds that sell and redeem shares directly with investors, ETFs have a unique creation and redemption process that involves third-party specialists called authorized participants (APs). When purchasing an ETF share, public investors are buying and selling a collective exposure to the underlying basket of securities. As such, the ETF architecture generally consists of the primary market, where the underlying basket of securities is assembled, and the secondary market, where the ETF shares are publicly traded. Dealer inventory, which is the ETF shares held by dealers, is referred to as an additional layer of "liquidity." The three layers are depicted in Figure 3 , defined in the Glossary of Terms textbox, and explained further in the following sections. In a typical ETF creation process, the ETF sponsor would first publish a list of securities in an ETF share basket. The APs have the option to assemble and deliver the securities basket to the ETF sponsor. Once the sponsor receives the basket of securities, it would deliver new ETF shares to the AP. The AP could then sell the ETF shares on a stock exchange to all investors. The redemption process is in reverse, with the APs transferring ETF shares to sponsors and receiving securities. ETF shares are created and redeemed by authorized participants in the primary market. The fund sponsors do not sell their ETF shares directly to investors; instead, they issue the shares to APs in large blocks called "creation units" that usually consist of 50,000 or more shares. The APs' creation and redemption process often involves the purchase of the created units "in-kind" rather than in cash. This means that the shares are exchanged for a basket of securities instead of cash settlements. The supply of ETF shares is flexible, meaning that the shares can be created or redeemed to offset changes in demand; however, only authorized participants can create or redeem ETF shares from the sponsors. A large ETF may have dozens of APs, whereas smaller ETFs could use fewer of them. Most ETF shares are traded on national exchanges, creating a visible source of liquidity through public trading activities. The ETF liquidity on an exchange is driven largely by supply and demand of the public secondary market participants. This is very different from open-end mutual funds that derive liquidity only from the fund providers. Most ETF shares trade many more times on exchanges in the secondary market than through the primary market creation/redemption process. For example, $2.1 trillion in total U.S. ETFs were involved in around $18 trillion of secondary market transactions in the 12 months that ended June 2015. Many consider secondary market liquidity to be additive, meaning ETFs' liquidity is at least as great as that of its underlying assets. This is because secondary market trading does not require underlying securities transactions. In addition to primary and secondary market liquidity, large broker-dealers serving as market makers assemble their own inventory of ETF shares through direct contacts with APs for price quotes, instead of going through the exchanges. This is called "nondisplayed" liquidity, meaning the transaction information is not part of readily accessible public records. In other words, there are multiple quotes at which an investor can transact. For most ETFs, market makers will publish quotes beyond the national best bid and offer quotes. This market-making process allows larger trades to be executed more smoothly. Both mutual funds and ETFs are required to calculate their funds' worth as measured by net asset value (NAV) each business day. But ETF shares are traded intraday on exchanges; as such, an ETF's market share price (in the secondary market) could differ, at a particular time, from the value of its underlying basket (in the primary market) as expressed in the fund's NAV. The arbitrage process is a common ETF mechanism to help align the ETF share trading price with its underlying NAV. Arbitrage is the simultaneous buying and selling of securities to profit from price imbalance without being subject to additional risks. With ETFs, differences in price between primary and secondary markets create arbitrage opportunities that could be captured from either the primary market (via APs) or the secondary market (via ordinary open-market participants). Arbitrageurs would simultaneously buy or sell ETF shares and their underlying assets. AP-enabled arbitrage activities are done in the primary market involving creation units, whereas ordinary market participants would conduct arbitrage through open-market operations in the secondary market. To illustrate the process, when an ETF's price is far above the price of its underlying stocks or bonds, the arbitrageurs would buy the underlying securities and exchange them for ETF shares. This activity would create new supply and demand dynamics that would align the price of the shares with their underlying assets. When ETF shares trade at below NAV, arbitrageurs would purchase the shares and exchange them for the underlying securities. The arbitrageurs are motivated by the transactions' economic incentives to bridge the gap between the market price and the value of the underlying assets. The APs are not obligated to create or redeem shares to enable the arbitrage mechanism through the creation and redemption process. Should market stress or some other event cause APs to simultaneously exit the market, then the ETFs would trade like closed-end funds, which would still have access to secondary-market liquidity, but would be unable to create or redeem shares. Closed-end funds are investment companies that generally sell a fixed number of shares at an initial public offering and then trade on a secondary market thereafter without continuously offering their shares for sale. The expectations are that if the ETFs trading as closed-end funds widen their arbitrage opportunities, the increased economic incentives would attract new APs to enter the market and resume creation and redemption. The first U.S. ETF was introduced in 1993 to track the S&P 500 index. Because it was an innovative product at the time, it did not fit completely within any of the existing statutory schemes for securities, investment companies, or listing standards. As such, ETFs "piggybacked" off the existing regulation for mutual funds and securities; the first-ever ETF took four years to gain SEC approval. Even at their current scale ( Figure 1 ), ETFs continue to operate within a "patchwork" of regulations. ETFs in the United States are generally registered as open-end investment companies or unit investment trusts under the Investment Company Act of 1940. Although ETFs combine the characteristics of both mutual funds and stocks, they are structurally different from stocks and mutual funds, and do not fit into existing securities or investment company regulations. As such, to offer an ETF, the sponsor and the intermediaries must comply with and obtain various exemptive reliefs from a patchwork of statutory provisions. ETFs generally have the following characteristics: Investment companies that comply with and gain exemptive relief from the Investment Company Act of 1940 (1940 A ct). ETFs often obtain exemptions from certain structural and operational requirements under the SEC 1940 Act that are not consistent with their operations. The 1940 Act differs from other major U.S. securities laws.