How Does an ETF Work? A Clear and Simple Explanation

After understanding what an ETF is, the next step is to learn how it actually works.
Many investors buy ETFs without knowing what happens behind the scenes — how the fund tracks an index, how shares are created, or why ETFs can be traded like stocks.

This article explains everything in a simple, beginner-friendly way.

What Makes ETFs Unique?

ETFs are different from mutual funds in one important way:
They can be bought and sold on the stock exchange in real time.

But how is that possible?

The answer lies in the creation and redemption process, the market maker system, and replication methods — all of which make ETFs efficient, liquid, and low-cost.

Let’s break it down.

How ETFs Track Their Index

Every ETF is designed to follow a specific index (e.g. MSCI World, S&P 500, Nasdaq 100).
To do that, it needs a method to replicate the index.

There are three main replication methods:

1. Physical Full Replication

The ETF buys all components of the index.

Example:
An S&P 500 ETF buys all 500 companies in the exact weights of the index.

Advantages:

• very transparent
• easy to understand
• minimal counterparty risk

Disadvantages:

• complex or expensive for very large or illiquid indices

2. Physical Sampling (Optimised Sampling)

The ETF buys only the most representative securities of the index.
This is used when an index has thousands of constituents.

Example:
Instead of buying all 1,600 stocks in MSCI Emerging Markets, the ETF buys the most important ones to mirror performance.

Advantages:

• cheaper to run
• easier to manage

Disadvantages:

• small deviation from index performance (tracking difference)

3. Synthetic Replication

Instead of holding all assets, the ETF uses a swap contract with a partner bank.
The bank guarantees the return of the index.

Think of it like this:
The ETF holds a basket of different assets while a bank “swaps” the performance with the ETF for the target index.

Advantages:

• better tracking accuracy
• useful when physical replication is difficult (e.g. commodities, niche markets)

Disadvantages:

• counterparty risk
• more complex structure

How ETF Shares Are Created and Removed

This is where ETFs truly differ from traditional funds.

ETFs are kept efficient through the Creation/Redemption Process using special institutions called Authorized Participants (APs).

How It Works

Step 1: Creation

1. APs buy the underlying assets (e.g. all S&P 500 stocks).
2. They deliver them to the ETF provider.
3. In return, they receive newly created ETF shares.
4. These shares are sold on the stock exchange to investors.

This ensures that ETF supply increases when demand rises.

Step 2: Redemption

1. APs collect ETF shares from the market.
2. They return them to the ETF provider.
3. The ETF provider gives back the underlying assets.
4. The ETF shares are destroyed.

This ensures supply decreases when demand falls.

Why This System Matters

This mechanism provides:

• High liquidity
• Accurate prices
• Tight bid-ask spreads
• Reliable tracking of the index

Even if an ETF has low trading volumes, the underlying assets are liquid — which keeps the ETF liquid too.

The Role of Market Makers

Market makers are institutions that ensure there is always a buy and sell price available for the ETF.

Their responsibilities:

• publish continuous bid and ask prices
• ensure spreads stay tight
• keep ETF price close to the value of its underlying assets

If the ETF price diverges from the index, APs and market makers step in to arbitrage the difference.

This keeps prices aligned with the fair value.

What Is the NAV (Net Asset Value)?

The NAV is the value of all assets inside the ETF divided by the number of shares.

Example:
If the ETF holds assets worth $100 million and 5 million shares exist:
NAV = $20 per share.

NAV is calculated once per day — but ETF prices move continuously on the stock exchange.

The Difference Between NAV and Market Price

Because ETFs trade constantly, their market price can be slightly higher or lower than the NAV.

• If ETF price > NAV → premium
• If ETF price < NAV → discount

Arbitrage keeps these differences small.

Why ETFs Are So Liquid and Efficient

ETFs have two layers of liquidity:

1. Primary Market (Creation/Redemption)

Institutional liquidity — unlimited in theory.

2. Secondary Market (Stock Exchange Trading)

Retail and institutional trading — what investors see.

Even if trading volume appears low, ETFs remain highly liquid because APs and market makers can always create or redeem shares.

Conclusion

ETFs work through a combination of:

• efficient index replication
• a unique creation and redemption system
• arbitrage mechanisms
• market maker support

Together, these features make ETFs transparent, liquid, cost-effective, and ideal for long-term investors.

---

→ Next Article: Types of Equity ETFs — The Core of Every Portfolio

In the next article, we explore the most important ETF category and break down global, regional, sector, and style-based equity ETFs.