Understanding the structure of an exchange traded fund will help understand some of the less obvious benefits ETFs have over mutual funds.
Essentially, ETFs are open-ended index mutual funds that are listed and traded on exchanges like stocks. ETFs track a basket of securities -- like stocks, bonds or commodities -- that are identified using a fixed set of rules that make up the index's strategy, and the returns of the ETF are based on the returns of the underlying assets held in the basket. The ETF will not replicate the index performance exactly due to expenses and tracking error inherent in the investment process.
But behind the scenes, the unique creation and redemption process within the ETF structure enables it to provide other advantages such as lower expenses, fewer taxable events and better liquidity.
