How Do ETFs Work: From a Financial Advisor
May 8th, 2025
Exchange-Traded Funds (ETFs) offer a mix of diversification, flexibility, and cost efficiency. Used by both institutional and individual investors, they have become a staple in many portfolios by combining some of the most beneficial features of stocks and mutual funds into a flexible investment option.
But what exactly are ETFs, and how do they work?
1. ETFs Are Investment Funds That Trade Like Stocks
Think of an ETF like a well-balanced sports team. Instead of relying on a single superstar player (an individual stock), a strong team has a mix of players that help keep the team competitive, even if one underperforms.
Similarly, an investor considering technology stocks could:
● Buy shares of individual companies, which carries higher risk.
● Invest in a technology-focused ETF, which holds multiple major tech companies, reducing risk through diversification.
Unlike mutual funds, which are priced once daily at market close, ETF’s trade throughout the day at market prices, similar to stocks.
2. How ETFs Are Created and Managed
ETFs operate through a creation and redemption process so their price usually follows the value of their underlying assets.
Large financial institutions, called Authorized Participants (APs), create new ETF shares by exchanging a basket of securities for ETF shares, and vice versa. This prevents significant price deviations between the ETF and its holdings.
Put simply, if demand for an ETF rises, APs create more shares to meet supply, preventing extreme price fluctuations.
3. The Different Types of ETFs and Their Uses
ETFs come in various forms, each serving different investment goals:
● Broad Market ETFs – Track major indexes (S&P 500, Nasdaq, MSCI World).
● Sector ETFs – Focus on specific industries (e.g., tech, healthcare, energy).
● Bond ETFs – Provide exposure to government, corporate, or municipal bonds.
● Commodity ETFs – Invest in physical assets like gold, oil, or agriculture.
● Dividend ETFs – Hold income-generating stocks for passive income.
● Inverse & Leveraged ETFs – They are intended for short-term strategies and may not be suitable for most investors. They carry higher risk and should be used only by those who understand their unique structure.
Because ETFs are versatile, investors can customize their portfolios to align with their risk tolerance and financial goals.
For example, a retired investor may prefer bond ETFs and dividend ETFs for steady income, while a younger investor might opt for growth ETFs for long-term capital appreciation.
4. Potential Risks of ETFs
While ETFs offer many advantages, like all investments, they involve risks. Here are a few key risks investors should understand:
● Market Risk – ETFs can lose value as market conditions change.
● Tracking Error – Some ETFs may not perfectly match the performance of the index they track.
● Liquidity Concerns – Niche ETFs with lower trading volume can be harder to buy and sell, leading to higher transaction costs or difficulty selling shares during downturns.
ETFs offer a blend of diversification, efficiency, and flexibility, making them an attractive choice for both passive and active investors. While they do carry risks, as all investments do, ETFs can be a cost-effective way to access markets, manage risk, and enhance portfolio diversification. Speak with your financial advisor to determine which ETFs best fit your investment goals and risk tolerance.
Sources:
https://oechsli.com/my-account/us/library/98072/
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or advisor for specific information pertaining to your situation
Inverse/Leveraged ETF Leveraged and inverse exchange traded funds ("ETFs") are for sophisticated investors who understand their risks including the effect of daily compounding of leveraged investment results and for accounts that will be actively monitored and managed on a daily basis. These products require an Aggressive Growth Investment Objective and a High Risk stated risk tolerance on an executed Confidential Investor Profile to purchase. The more an ETF invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. Inverse ETFs involve certain risks, which include increased volatility due to the ETF's possible use of short sales of securities and derivatives, such as options and futures. The ETF's use of derivatives, such as futures, options and swap agreements, may expose the ETF's shareholders to additional risks that they would not be subject to if they invested directly in the securities underlying those derivatives. Short-selling involves increased risks and costs. You risk paying more for a security than you received from its sale. Leveraged and inverse ETFs seek to provide investment results that match the performance of a specific benchmark, before fees and expenses, on a daily basis. Inverse ETFs should lose money when their benchmarks or indexes rise - a result that is opposite from traditional ETFs. ETFs are non-diversified investments. These risks can increase volatility and decrease performance.
