Here's the simplest way to picture it: imagine a basket containing all 500 companies in the S&P 500. Instead of buying 500 individual stocks, you buy one share of an ETF that owns the whole basket. As the companies inside grow in value, so does your share.
That single-purchase diversification is the core appeal of ETFs, enabling you to spread your money across many investments in one trade, at low cost. ETFs operate in two places at once, and understanding both is the key to understanding how they work. The stock exchange (where you trade).
On the exchange, ETF shares are bought and sold all day long between investors, just like Apple or Tesla stock. The price moves throughout the trading day based on supply, demand, and the value of the underlying holdings. This is the market you interact with when you place a buy order in your brokerage account.
The creation/redemption mechanism (behind the scenes). This is the clever engine that makes ETFs work, and what separates them from ordinary stocks. Large institutions called "authorized participants" (APs) can create new ETF shares by delivering the fund the underlying basket of securities, or redeem shares by handing them back in exchange for those securities.
If an ETF's market price drifts above or below the value of its holdings, APs step in to arbitrage the difference, creating or redeeming shares until the price snaps back in line. The result is that an ETF's trading price stays very close to the actual value of the assets it holds (its net asset value, or NAV). This behind-the-scenes process is also why ETFs are so tax-efficient: because shares are often redeemed in-kind (swapped for securities rather than sold for cash), the fund avoids triggering the capital gains that mutual funds regularly pass on to their investors.
Most ETFs are passively managed, meaning they aim to match a specific index rather than beat it. An S&P 500 ETF, for example, holds the same 500 stocks as the index, in the same proportions. If Apple is 7% of the index, it's roughly 7% of the ETF.
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