What are iShares?

Created by Barclays Global Investors, iShares are a trademarked brand of exchange-traded funds (ETFs).

How Do iShares Work?

Exchange-traded funds (ETFs) are securities that closely resemble index funds but can be bought and sold during the day just like common stocks. Essentially, iShares offer the convenience of a stock along with the diversification of a mutual fund.

However, exchange-traded funds don't sell shares directly to investors. Instead, each ETF sponsor issues large blocks (often of 50,000 shares or more) that are known as creation units. These units are then bought by an 'authorized participant' -- typically a market maker, specialist or institutional investor -- which obtains shares of the underlying securities and places them in a trust. The authorized participant then splits up these creation units into ETF shares -- each of which represents a legal claim to a tiny fraction of the assets in the creation unit -- and then sells them on a secondary market.

Just as closed-end funds don't always trade at a price that precisely reflects the value of the underlying assets in each share of the portfolio, it is also possible for an ETF to trade at a premium or a discount to its actual worth. To liquidate their holdings, most investors simply sell their ETF shares to other investors on the open market. However, it is possible to amass enough ETF shares to redeem them for one creation unit and then redeem the creation unit for the underlying securities. Because of the large number of shares involved, individual investors seldom use this option.

Why Do iShares Matter?

iShares, and exchanged-traded funds in general, have grown increasingly popular, and the number of iShares choices has swelled into the hundreds since the first iShares product launched in 1996. Today, these securities compete with mutual funds and offer a number of advantages over their predecessors, including: lower trading costs (loads), high liquidity, tax advantages and transparency and diversification regarding the underlying assets.

As with any security, the pros and cons should be weighed carefully, and investors should first do their homework to determine whether exchange-traded funds are the appropriate vehicle to meet their individual goals and objectives.