What is an ETF
An ETF (exchange-traded fund) is an investment fund whose units trade on a stock exchange during market hours, like shares of a company. Buying a unit gives you a proportional share of everything the fund holds. That can be a basket of stocks, bonds, gold or other assets.
Most ETFs are passive. They do not try to pick winners. They try to follow an index, which is a rule-based list of securities, such as the largest listed companies in a market. If you are new to these building blocks, start with what stocks are and what bonds are.
An ETF is an investment product, not a savings account. Its price can fall, and you can get back less than you put in.
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How ETFs work
Index tracking
The fund manager holds assets so that the fund's value moves in line with its chosen index. When the index provider changes the list, for example by adding a company and removing another, the fund rebalances to match.
No ETF tracks its index perfectly. The gap between the fund's return and the index return is called tracking difference. How much that gap varies over time is called tracking error. It comes from:
- fees taken from the fund's assets
- trading costs when the fund rebalances
- cash held for dividends or redemptions
- sampling, where the fund holds only part of the index instead of every security
For experienced investors, a fund's tracking difference over several years is usually a better measure of cost than the stated fee alone.
Creation and redemption
ETF units are created and cancelled by large institutions called authorised participants (APs). When demand pushes the ETF's market price above the value of its holdings, APs can deliver the underlying assets to the fund and receive new units to sell. When the price drops below that value, they do the reverse. This arbitrage keeps the market price close to the NAV (net asset value, the value of the fund's holdings per unit). It does not keep it exactly equal.
Many ETFs also publish an iNAV, an indicative value updated during the trading day. Comparing it with the market price shows whether you are paying a premium or getting a discount.
ETF costs: expense ratio and more
The expense ratio is the yearly fee the fund charges, expressed as a percentage of your holding. It is not billed to you separately. It is taken from the fund's assets bit by bit, so it shows up as a slightly lower NAV. The fund's factsheet and offering documents state the current figure.
The expense ratio is only part of the cost. Others include:
| Cost | Where it appears |
|---|---|
| Expense ratio | Deducted inside the fund, reduces NAV |
| Brokerage commission | Charged by your broker on each buy and sell |
| Bid-ask spread | Difference between buying and selling price on the exchange |
| Premium or discount to NAV | Paying above or selling below the holdings' value |
| Taxes and levies | Set by law and the exchange; check current rules |
Small, rarely traded ETFs can have wide spreads that cost more than the expense ratio. Over long periods, even small yearly fees reduce results through compounding. You can see the effect with the tools on the calculators page and in compound interest explained.
Physical vs synthetic ETFs
The two broad approaches differ in how the fund gets exposure to its index.
Physical replication
The fund buys the actual securities in the index.
- Full replication: it holds every security in the index weights.
- Sampling: it holds a representative subset. Funds often do this when the index is large or some securities are hard to trade.
Some physical funds lend securities to other market participants for a fee. This adds income but also adds counterparty risk, the risk that the borrower fails to return them. The fund documents should say whether lending is used.
Synthetic replication
The fund does not hold the index securities. It enters a swap, a contract in which a bank pays the fund the index return in exchange for the return on a collateral basket the fund holds. Synthetic ETFs can track hard-to-reach markets closely. The cost of that is reliance on the swap counterparty and on the quality of the collateral.
Commodity ETFs work in different ways again. Some hold the physical metal in a vault. Others use futures contracts, and these can drift from the spot price when contracts are rolled. See gold in Pakistan for the background on local gold pricing.
Trading ETFs on an exchange
Because ETFs are listed, you buy and sell them through a stockbroker at the market price, using the same order types as for shares:
- Market order: executes at the best available price. That price can be poor in thin markets.
- Limit order: executes only at your price or better. This is useful when spreads are wide.
You see the price before you trade, unlike a mutual fund, which is priced once a day after the market closes. Liquidity depends both on the ETF's own trading volume and on how easily the underlying assets trade.
ETF in Pakistan
Regulator: Securities and Exchange Commission of Pakistan (SECP), with trading in listed securities and commodities only via SECP-licensed securities and futures brokers. In practice, an investor in Pakistan who wants exchange-listed products, ETFs included, goes through a licensed securities broker. On broker lists, per the SECP, lists of licensed brokers are on the PSX and PMEX websites. Check the PSX website for which ETFs are currently listed, along with their factsheets and trading data. The basics of accounts and settlement are covered in PSX basics.
Shariah-compliant ETFs that track Islamic indices may be available. See Islamic finance for the principles behind screening.
Be careful with unregulated offers. On offshore platforms, per the SECP, offshore platforms have no Pakistani licence or oversight and offer no legal protection or recourse. More detail is in law and regulators.
Owning an ETF is different from trading an index CFD. An ETF unit is a share of a fund that owns assets. A CFD is a leveraged contract on price movement, and it can lose money fast. See stock indices for how index CFDs work.
ETF vs mutual fund
| Feature | ETF | Conventional mutual fund |
|---|---|---|
| How you buy | On the exchange via a broker | From the fund manager or distributor |
| Pricing | Continuous market price during trading hours | Once a day at NAV |
| Typical style | Mostly passive index tracking | Often actively managed |
| Costs | Expense ratio plus brokerage and spread | Expense ratio, possibly sales loads |
| Price vs NAV | Can trade at a premium or discount | Transacts at NAV |
Both pool money and spread it across many holdings, which supports diversification. For more, read mutual funds and index investing.
Frequently asked questions
What is an ETF in simple words?
It is a fund that holds a basket of assets, usually following an index, and its units trade on a stock exchange like shares.
Are ETFs safe?
No investment is free of risk. An ETF's value moves with the assets it holds, so it can fall sharply when its market falls.
Do ETFs pay dividends?
Some pass on dividends from their holdings, and others reinvest them. The fund documents say which. See dividends explained.
Is an ETF the same as an index fund?
Many ETFs are index funds, but they trade on an exchange. A conventional index fund is bought from the manager at the daily NAV.
Where do I check current ETF fees and prices?
Check the fund's factsheet, the PSX website and your licensed broker. Use only dated, official figures.