Learn how ETFs work, how they track market indexes, and what affects their prices. Explore ETF types, costs, tracking differences and index CFDs.
Updated September 30, 2026
Learn how ETFs work, how they track market indexes, and what affects their prices. Explore ETF types, costs, tracking differences and index CFDs.
An exchange-traded fund (ETF) works by pooling investors' money into a single fund that holds a basket of assets, such as shares, bonds or commodities, and then dividing that fund into shares that trade on a stock exchange throughout the day, just like individual stocks. Most ETFs are designed to track a market index, such as a benchmark of the largest companies in a country, and they do this either by holding the same securities as the index in the same proportions or by holding a representative sample of them. What keeps an ETF's price closely aligned with the value of what it holds is a behind-the-scenes mechanism called creation and redemption, in which large financial institutions constantly create new ETF shares or redeem existing ones to close any gap between the fund's market price and the value of its underlying assets. The result is a product that offers broad, low-cost market exposure in a single trade; the honest caveat is that no ETF tracks its index perfectly, and understanding why is part of choosing the right one.
This guide explains what happens inside an ETF: what you actually own when you buy a share, how funds track an index, the difference between physical and synthetic replication, how the creation and redemption process works, why ETF prices stay close to their underlying value, why tracking is never perfect, and what costs come with owning one. It also looks at specialised products like leveraged and inverse ETFs, which behave very differently from standard funds, and at how trading an index through CFDs differs from owning an ETF. The recurring theme is that ETFs look simple from the outside, but knowing how the structure works helps you judge which funds genuinely deliver the exposure they promise. Skyriss believes that understanding the instruments behind the market is the foundation of every sound decision, whether you're investing for the long term or trading shorter-term price moves. This article is educational and does not constitute investment advice; investing and trading carry risk, including the possible loss of the money you put in.
For those who want the essentials immediately, here's how it works.
An ETF is a fund that holds a portfolio of assets and issues shares that trade on an exchange at market prices throughout the day. Most ETFs track an index, either by holding every security in it (full replication), holding a representative selection (sampling), or using financial contracts called swaps to deliver the index return (synthetic replication). The fund's shares are created and redeemed in large blocks by authorised participants, specialist institutions that exchange baskets of the underlying securities for ETF shares and vice versa. When an ETF's price drifts above or below the value of its holdings, these institutions have a profit incentive to create or redeem shares, which pushes the price back in line.
ETFs don't match their index exactly. The gap, known as tracking difference, comes mainly from fees, trading and rebalancing costs, cash held in the fund, and sampling methods. Owning an ETF also involves an annual expense ratio and the bid-ask spread paid when buying or selling. Leveraged and inverse ETFs reset daily and can drift significantly from their stated multiple over longer periods. The rest of this guide explains each of these in depth.
At its core, an ETF is a pooled investment fund with one key difference from a traditional mutual fund: its shares are listed and traded on a stock exchange.
When you invest in a traditional mutual fund, you buy and sell units directly with the fund manager, typically once a day at a price calculated after the market closes. An ETF, by contrast, trades like a stock. You can buy or sell it at any point during market hours at the current market price, place limit orders, and see its price move in real time. That combination of a diversified fund structure with the flexibility of stock trading is what has made ETFs one of the most widely used investment products in the world.
You own a proportional share of the fund, not direct ownership of the individual securities inside it. If an ETF holds 500 companies, one ETF share represents a small slice of that entire portfolio and of the income it generates, such as dividends or interest. The fund itself legally holds the underlying assets, which are typically kept with an independent custodian, separate from the fund provider's own assets. Depending on the fund, income is either paid out to shareholders (distributing ETFs) or reinvested back into the fund (accumulating ETFs).
Most ETFs are passive, meaning their goal isn't to beat the market but to mirror the performance of a specific index as closely as possible.
An index is a rules-based list of securities designed to represent a market or a segment of it: the largest companies in a country, a particular sector, government bonds of a certain maturity, and so on. Index providers set the rules for which securities are included, how much weight each one carries and how often the list is reviewed. Many major equity indices are market-capitalisation weighted, meaning larger companies make up a larger share of the index. Others use equal weighting, dividend yield or other criteria. The ETF's job is to follow whatever those rules produce.
ETFs track their indices in two main physical ways. Full replication means the fund buys every security in the index in the same proportions. This is the most direct approach and usually delivers the closest tracking, which is why it's common for indices made up of large, liquid companies. Sampling, sometimes called optimisation, means the fund holds a representative subset of the index designed to match its overall characteristics, such as sector weights, country exposure and risk profile. Sampling is used when an index contains thousands of securities, or includes assets that are expensive or difficult to trade, where buying everything would add cost without meaningfully improving accuracy.
Not every ETF holds the assets it tracks.
A physical ETF owns the underlying securities directly, through full replication or sampling. A synthetic ETF instead holds a separate basket of assets and enters into a swap agreement with a counterparty, usually a bank, which agrees to pay the fund the return of the index in exchange for the return on the basket. Synthetic structures can track certain hard-to-access markets more efficiently and sometimes more cheaply.
The trade-off is counterparty risk: the fund depends on the swap provider honouring its commitment. Regulated synthetic ETFs are typically required to limit that exposure and hold collateral, but it remains a structural difference investors should understand. Checking whether a fund is physical or synthetic, and reading how it manages counterparty exposure, is part of understanding what you're really buying.
This is the mechanism that makes ETFs work, and it's the part most investors never see.
Unlike a stock, the number of shares in an ETF isn't fixed. New shares are created when demand rises, and existing shares are removed when demand falls. This happens through large institutions called authorised participants, which are typically major banks and market-making firms with agreements with the fund provider.
To create new ETF shares, an authorised participant assembles a basket of the underlying securities that matches the fund's holdings and delivers it to the ETF provider. In return, it receives a large block of newly created ETF shares, known as a creation unit, which it can then sell on the exchange. Redemption works in reverse: the authorised participant returns a block of ETF shares to the provider and receives the underlying securities, or in some cases cash, in exchange. Everyday investors never interact with this process directly; they simply buy and sell ETF shares on the exchange, while authorised participants and market makers manage supply in the background.
Every ETF has a net asset value (NAV), which is the total value of its holdings divided by the number of shares. During trading hours, an estimated intraday value is also published so market participants can see what the fund's holdings are worth in real time. The ETF's market price, however, is set by buyers and sellers on the exchange, so in theory it could drift away from that value.
In practice, creation and redemption keep the two closely aligned through arbitrage. If an ETF trades above the value of its holdings, authorised participants can buy the cheaper underlying securities, exchange them for new ETF shares and sell those shares at the higher market price, locking in a profit. That extra supply pushes the ETF's price back down. If the ETF trades below its underlying value, they can buy the cheaper ETF shares, redeem them for the more valuable underlying securities and sell those, which reduces supply and lifts the price. This constant profit-seeking activity is what keeps well-functioning ETFs trading very close to the value of what they hold.
Gaps can widen when the underlying market is harder to trade or price. ETFs holding less liquid assets, such as some corporate bonds or emerging market securities, can trade at noticeable premiums or discounts, particularly during periods of market stress. Timing also matters: an ETF tracking an overseas market that's closed during local trading hours reflects expectations about where those assets will open, so its price may differ from the last published value. For widely held funds tracking large, liquid markets, these gaps are usually very small.
An index is a theoretical calculation; it has no costs, holds no cash and rebalances instantly. A real fund has to operate in the real market, which creates small differences in performance.
Two terms are worth knowing here. Tracking difference is the gap between the ETF's return and the index's return over a period, and it tells you how much, on average, the fund has lagged or outperformed its benchmark. Tracking error measures how consistently the fund follows the index, meaning how much that gap varies over time. A good ETF has both a small tracking difference and a low tracking error.
The main causes of the gap are the fund's ongoing fees, which are deducted from its assets; trading and rebalancing costs when the index changes; cash drag, from holding small amounts of uninvested cash, such as dividends waiting to be paid out; sampling, where the fund doesn't hold every index security; and withholding taxes on dividends from certain countries. Some funds partly offset these costs by lending out their securities to other institutions for a fee, which can narrow the gap. When comparing ETFs that track the same index, historical tracking difference is often more informative than the headline fee alone.
ETFs are known for being low cost, but they aren't free, and the full cost involves more than one number.
The expense ratio is the annual fee charged to run the fund, expressed as a percentage of your investment and deducted automatically from the fund's assets. Broad index ETFs often have very low expense ratios, while specialised, thematic and actively managed funds usually charge more. On top of that, every time you buy or sell, you pay the bid-ask spread, the difference between the price buyers are offering and sellers are asking; heavily traded ETFs typically have tight spreads, while smaller or niche funds can be more expensive to trade. Depending on your broker and location, there may also be commissions, currency conversion charges if the ETF is priced in a different currency from your account, and platform or custody fees. The true cost of an ETF is the combination of all of these over the time you hold it.
Yes, and understanding the differences matters because some of these products behave in ways that surprise investors.
Leveraged ETFs aim to deliver a multiple, such as two or three times, of an index's daily return, while inverse ETFs aim to deliver the opposite of the daily return. The key word is daily. These funds reset their exposure every day, which means that over longer periods, and especially in volatile, sideways markets, the effect of compounding can cause their performance to drift significantly from the stated multiple of the index's overall return. A leveraged ETF can lose value even if the index ends a volatile period roughly where it started. They are generally designed for short-term use by experienced traders, not long-term holding.
Actively managed ETFs, meanwhile, don't track an index at all. A portfolio manager selects the holdings with the aim of outperforming a benchmark or meeting a specific objective. They offer the trading flexibility of an ETF, but typically come with higher fees and the risk that the manager's decisions underperform the market.
Both let you gain exposure to a market index, but they are fundamentally different activities.
Owning an ETF means holding shares in a fund that owns (or synthetically tracks) the underlying assets; you're a part-owner of the portfolio, may receive dividends, and typically hold for the medium to long term. Trading an index through a contract for difference (CFD) means speculating on the index's price movement without owning any underlying assets or fund shares. CFDs allow traders to go long or short and usually involve leverage, which magnifies both gains and losses, making them a high-risk instrument suited to shorter-term trading rather than long-term investing.
Skyriss offers CFD trading on major global indices, the same benchmarks many ETFs are built to track, within a regulated environment. For traders, understanding how those indices are constructed and how ETFs follow them adds valuable context to reading index price action. For long-term investors, an ETF is the more natural vehicle. Knowing which approach fits your goals is the first step.
An ETF pools money from many investors into a fund that holds a basket of assets, then divides that fund into shares that trade on a stock exchange throughout the day. Most ETFs aim to track an index, giving investors diversified exposure to a whole market or sector in a single trade.
Physical ETFs either buy every security in the index in the same proportions (full replication) or hold a representative sample designed to match the index's characteristics. Synthetic ETFs use swap agreements with a counterparty to deliver the index's return without holding its securities directly.
The creation and redemption process. Authorised participants create new ETF shares when the price trades above the value of the holdings and redeem shares when it trades below, profiting from the difference. This arbitrage keeps the market price close to the fund's net asset value.
Real funds have costs that indices don't, including management fees, trading and rebalancing costs, uninvested cash, sampling differences and withholding taxes. The resulting gap is called tracking difference, and comparing it across funds tracking the same index shows which ones follow it most efficiently.
Physical ETFs own the underlying securities. Synthetic ETFs hold a separate basket of assets and use a swap with a counterparty, usually a bank, to receive the index return. Synthetic funds introduce counterparty risk, which regulated funds typically limit through collateral requirements.
Generally not. Leveraged and inverse ETFs reset their exposure daily, so over longer periods, particularly in volatile markets, their returns can drift significantly from the stated multiple of the index. They're designed mainly for short-term trading by experienced traders.
No. Buying an ETF means owning shares in a fund that holds or tracks the underlying assets. Trading an index CFD means speculating on the index's price movement without ownership, usually with leverage, which magnifies both gains and losses and makes it a higher-risk activity.
ETFs have become one of the most popular ways to access the markets because they combine the diversification of a fund with the flexibility of a stock. But the simplicity on the surface is supported by a carefully designed structure underneath: index rules that define what the fund holds, replication methods that determine how closely it follows them, and a creation and redemption process that keeps the market price anchored to the value of the portfolio.
Understanding those mechanics turns ETF selection from a guess into an informed decision. It helps you look past the headline fee to tracking difference and trading costs, recognise whether a fund is physical or synthetic, avoid holding daily-reset products for the long term by mistake, and see clearly whether you want to own a fund or trade the underlying index. Whether you're building a long-term portfolio or trading index price movements, knowing what's inside the wrapper is what separates confident decisions from assumptions. Explore global index markets with Skyriss at skyriss.com/get-started.
