Guide to ETFs
Complete guide to Exchange-Traded Funds, their structure, and market operations
Understanding Exchange-Traded Funds
Exchange-traded funds (ETFs) are investment vehicles whose shares trade intraday on exchanges and are typically designed to track an index. Since the first prototype launched in Canada in 1990, ETFs have revolutionized investing by combining the diversification of mutual funds with the trading flexibility of stocks. Today's $17.34 trillion global ETF market (as of July 2025) spans everything from broad market exposure to sophisticated quantitative strategies, fundamentally reshaping how both institutional and retail investors access markets.
What an ETF Is—And Why Its Structure Matters
An exchange-traded fund (ETF) is an investment vehicle whose shares trade intraday on exchanges and that is typically designed to track an index. The key architectural feature is a primary market in which large broker-dealers known as authorized participants (APs) create and redeem ETF shares—often in kind—against baskets of the underlying assets; and a secondary market in which investors trade ETF shares with one another.
Dual Market Structure
This dual-market structure and the associated arbitrage activity are central to pricing efficiency, liquidity provision, and tax outcomes.
- •Primary Market: Where authorized participants create/redeem ETF shares
- •Secondary Market: Where investors trade ETF shares on exchanges
Key Advantages
Price Efficiency
The creation/redemption process helps keep ETF prices close to the fund's net asset value (NAV): deviations invite arbitrage by APs
Tax Efficiency
Because many ETFs handle flows with in-kind transfers (rather than selling portfolio holdings), they can minimize realized capital-gains distributions
A Brief History: From Canada's Prototype to Today's Global Industry
The modern ETF lineage begins in Canada: the Toronto 35 Index Participation Units ("TIPs") launched on the Toronto Stock Exchange on March 9, 1990, widely regarded as the world's first exchange-traded, index-linked product and prototype for today's ETFs.
Timeline of Key Milestones
How ETFs Work in Detail
Creation/Redemption Process
Creation/redemption is the transmission belt connecting ETF share prices to portfolio value. APs assemble (or receive) "baskets" of securities (or cash) to create (or redeem) "creation units" with the ETF sponsor.
The Process:
- 1.Authorized Participant identifies arbitrage opportunity
- 2.AP assembles basket of underlying securities (creation) or ETF shares (redemption)
- 3.Exchange occurs with ETF sponsor (usually in-kind)
- 4.Price-NAV gap narrows through arbitrage
Use Cases Across Investor Types
Institutions
ETFs facilitate rapid, diversified exposures (country/sector/factor), hedging, and transitions; fixed-income ETFs have supported portfolio trades and risk management when single-bond liquidity is thin
Advisors & Model Portfolios
The standardized structure, transparent rules, and cost profile have made ETFs the core building blocks in model portfolios globally
Taxable Investors
For investors in taxable accounts, in-kind flows can reduce distributed capital gains compared with traditional mutual funds holding similar assets
Retirement & Retail
The ability to trade intraday, obtain diversified exposures with small tickets, and select among a very wide set of asset classes are documented advantages
Strategies Born (or Scaled) Because of ETFs
Broad Beta & Precise Tilts
The earliest ETFs delivered market-cap indexes; today's menu includes granular sectors, countries, durations, credit qualities, commodities, and currencies, enabling portable, low-cost tilts that are easily combined in quant overlays.
Available Exposures
Market-Wide Effects and Risks: What the Literature Says
Volatility and Comovement
Using index reconstitutions to obtain exogenous variation, Ben-David, Franzoni, and Moussawi (2018, Journal of Finance) find that stocks with higher ETF ownership exhibit significantly higher volatility and turnover, consistent with ETF arbitrage adding a layer of trading.
Fixed-Income Liquidity Under Stress
Studies and official reports investigate AP participation and ETF primary-market functioning in corporate-bond ETFs. Evidence suggests ETFs can act as "liquidity buffers" at times, with secondary-market trading absorbing pressure even when bond trading is thin.
International Capital Flows
A Federal Reserve study shows that the growing role of ETFs increased the responsiveness of flows into emerging markets to global financial conditions—an important consideration for sovereigns and global macro investors.
Regulatory Perspectives
IOSCO's ETF good-practices report and BIS analyses emphasize the importance of basket transparency, liquidity classifications, and robust AP incentives for orderly functioning, particularly in less liquid asset classes.
Who Benefits—And How to Use ETFs Well
For long-horizon investors, broad, low-cost index ETFs remain powerful cores, with potential tax advantages in taxable accounts. For advisors, ETFs simplify rebalancing and scalable model portfolio implementation.
Best Practices for Different Investors
Long-Term Investors
Focus on broad, low-cost index ETFs as portfolio cores with tax efficiency benefits
Quant Investors
ETFs are flexible building blocks enabling portable betas, granular hedges, factor sleeves, options overlays, and access to alternative premia—but require careful modeling
All Investors
The academic and regulatory literature consistently recommends attention to underlying market liquidity, disclosure cadence (for active ETFs), and the robustness of the arbitrage channel
The State of the Market—By the Numbers
$17.34 Trillion
Global ETF/ETP assets at end-July 2025
Source: ETFGI, Aug 27 2025
14,640
Products worldwide at end-July 2025
Source: ETFGI, Aug 27 2025
28,937
Exchange listings globally at end-July 2025
Source: ETFGI, Aug 27 2025
ETFs' combination of exchange trading, a scalable arbitrage channel, and rules-based (or increasingly active) portfolio design has reshaped investing. The literature advises modeling the mechanics, contexts, and externalities while harnessing the unparalleled toolkit ETFs provide for precise, low-friction exposures.
Important Disclaimer
This content is for educational and informational purposes only and does not constitute financial, investment, tax, or legal advice. The author is not a registered investment advisor, certified financial planner, or certified public accountant. Always consult with qualified professionals before making any financial decisions. Past performance does not guarantee future results. Investing involves risk, including potential loss of principal.
The information provided here is based on the author's opinions and experience. Your financial situation is unique, and you should consider your own circumstances before making any financial decisions.
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