Definition
An exchange-traded fund is an investment fund whose units are listed and traded on a stock exchange throughout the trading day, usually tracking an index, a sector or a basket of assets. It combines a pooled portfolio with the ability to buy and sell like a share.
How it works
Most ETFs are passive and aim to follow an index by holding its securities, either all of them or a representative sample, or by using derivatives. Large dealers called authorized participants (participating dealers in Hong Kong) create and redeem units in bulk, which helps keep the market price close to the net asset value.
Investors trade units through a broker at the market price, paying brokerage and crossing the bid-ask spread on top of the fund's ongoing expenses. What a seller receives is the market price, not the NAV, so spreads, premiums and discounts matter most for thinly traded or complex ETFs.
Illustrative example
Illustration with fictional figures: an ETF unit has a NAV of HK$20.00 and is quoted at HK$19.98 bid and HK$20.02 ask. Buying 1,000 units at the ask costs HK$20,020, while selling them straight back at the bid returns HK$19,980, so the spread alone costs HK$40, about 0.2%, before brokerage and the fund's expenses.
What to watch for
An ETF is not risk-free or automatically diversified: it can hold concentrated, leveraged or derivative-based exposures, and its price can differ from NAV. Check the index, replication method, fees and liquidity before assuming it behaves like a simple index tracker.