Investing Classroom

Course 101: Exchange-Traded Funds
In this course
1. Introduction
2. What Are Exchange-Traded Funds?
3. How Do ETFs Work?
4. The Pros of ETFs
5. The Cons of ETFs
6. Are ETFs for You?
7. Do ETFs Perform Better?
8. Conclusion
Quiz
Course Catalog

How Do ETFs Work?

Most ETFs cannot be bought from or sold back to the fund company like regular mutual funds. (The exception: Merrill Lynch's HOLDRs.) Investors can only buy or redeem shares directly from the sponsoring fund company in blocks (typically 50,000 shares), and even then, the funds require in-kind transactions. With an in-kind transaction, you don't get cash when you redeem your shares; you get the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of us have to go through a broker to buy and sell shares.

Unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares. To a large extent, the supply and demand for ETF shares are driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.

However, by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained price-to-NAV discrepancies from opening up.

If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. The actual transaction isn't quite that simple, but the idea is the same: The arbitrage opportunity would generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.

Next: The Pros of ETFs >>


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Before investing in investment company securities, be sure to carefully consider the security's objectives, risks, charges and expenses. For a prospectus containing this and other important information, contact the investment company or a
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ETFs are baskets of securities that may track a sector-specific, country-specific, or a narrow/broad-market index. ETFs trade on an exchange like a stock. ETFs are subject to risk similar to those of their underlying securities, including, but not limited to, market, sector, or industry risks, and those regarding short-selling and margin account maintenance. Commission fees typically apply.

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.

Risks of Commodity ETFs
Commodity ETFs may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Commodity ETFs may be subject to greater volatility than traditional ETFs and may not be suitable for all investors. Unique risk factors of a commodity fund may include, but are not limited to the fund's use of aggressive investment techniques such as derivatives, options, forward contracts, correlation or inverse correlation, market price variance risk and leverage.

Risks of Currency ETFs
The value of the shares of a currency exchange traded product relates directly to the value of the foreign currency held by the particular product. This creates a concentration risk associated with fluctuations in the price of the applicable foreign currency. Unique risk factors of a foreign currency include national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, investment and trading activities of institutions and global or regional political, economic or financial events and situations. Currency products may not be suitable for all investors. Many currency products are not investment companies registered under the Investment Company Act of 1940.For a more complete discussion of risk factors applicable to each currency product, carefully read the particular product's prospectus.

Risks of Bond ETFs
Investments in bond funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Bonds and bond funds will typically decrease in value as interest rates rise.

Risks of Leveraged and Inverse ETFs
Leveraged and inverse ETFs entail unique risks, including but not limited to: use of leverage; aggressive and complex investment techniques; and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.

Research and planning tools are obtained by unaffiliated third party sources deemed reliable by TD Ameritrade.
However, TD Ameritrade does not guarantee accuracy and completeness, and makes no warranties with respect to results to be obtained from their use. ETFs are baskets of securities that track recognized indexes and trade on an exchange like a stock. Commission fees apply.