How ETFs work

How ETFs work

Understanding how ETFs function can help investors make more informed decisions. While ETFs may seem straightforward on the surface, their structure and trading mechanics can be unique.

The basics of ETF structure

An ETF is created through a process involving authorized participants (APs), typically large financial institutions. These APs assemble the underlying assets of the ETF and deliver them to the ETF provider (in this case Fidelity) in exchange for “creation units,” which are large blocks of ETF shares. These shares are then broken up and sold on the stock exchange to individual investors.

When investors sell ETF shares, the process works in reverse, known as “redemption.” This in-kind creation and redemption process helps keep the ETF’s market price close to its net asset value (NAV). 

The diagram illustrates the ETF creation and redemption process. Authorized Participants (APs), typically large financial institutions, deliver a basket of underlying assets to the ETF provider (e.g., Fidelity) in exchange for creation units—large blocks of ETF shares. These shares are then broken up and sold on the stock exchange to individual investors. When investors sell ETF shares, the process reverses through redemption, where APs return ETF shares for the underlying assets. This in-kind mechanism helps keep the ETF’s market price aligned with its net asset value (NAV).
For illustrative purposes only

Trading ETFs on the exchange

Unlike mutual funds, which are only priced once per day, ETFs trade throughout the day at market prices. This means investors can use trading strategies such as:

  • Limit orders to control the price they pay
  • Stop-loss orders to manage downside risk
  • Dollar-cost averaging by buying at regular intervals

Understanding ETF pricing

An ETF’s price is influenced by:

  • NAV: The value of the underlying assets
  • Market demand: Supply and demand on the exchange
  • Bid-ask spread: The difference between the highest price a buyer is willing to pay and the lowest price a seller will accept

Why choose ETFs?

ETFs combine the diversification of mutual funds with the flexibility of stock trading. Understanding how they are built, traded, and taxed can help investors use them more effectively in their portfolios.

Interested in learning more?
Explore Fidelity ETFs