Exchange-traded funds have taken the investing world by storm. But many people don't know how they work. What's behind the most popular ETFs in the market?

In the following video, Dan Caplinger, The Motley Fool's director of investment planning, looks at ETFs and how they work. Dan notes that ETFs are very like mutual funds, helping you diversify your portfolio even with small amounts to invest. Unlike mutual funds, though, ETFs let you buy and sell shares throughout the day. Dan points out that unlike with mutual funds, ETFs involve buy shares on the open market, which in turn are controlled by authorized participants that create and redeem large blocks of shares. With equity ETFs, those actions involve stocks or cash; with bullion ETFs iShares Silver (NYSEMKT:SLV) and SPDR Gold (NYSEMKT:GLD), authorized participants use bullion to create or redeem ETF shares.

Dan points out that this mechanism makes it impossible to guarantee that ETFs trade at their net asset value. He concludes that sticking with liquid ETFs like SPDR S&P 500 (NYSEMKT:SPY) and Vanguard Total Stock Market ETF (NYSEMKT:VTI) is the best way to get fair value.

Fool contributor Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.