A recent study commissioned by the asset management industry forecasts that by 2015 half of available mutual funds will be replaced by exchange-traded funds (ETF).

This seems unlikely, at best. There’s currently more than $6.3 trillion invested in mutual funds, more than $10 trillion if money market funds are included.

But ETFs can be useful vehicles for investors. The first step toward making proper use of them in your portfolio is to understand how they work.

The defining difference between the two structures is the methods by which new shares are created and existing shares are redeemed.

Open-end mutual funds can mint an essentially limitless number of shares; every time a new investor buys into the fund new shares are created for him or her. When an investor decides to exit the investment, the shares are sold back to the fund itself. All buying and selling activity places the fund on one side of the transaction and the individual investor on the other.

As a function of that process, share prices are set by the fund itself at the end of the day and calculated by adding up the value of all the assets the fund owns and dividing that total by the number of outstanding shares. The net asset value (NAV) of the fund therefore reflects the value of the securities underlying each share of the fund.

ETFs are traded just like any other stock, with shares changing hands on the New York Stock Exchange or the Nasdaq, for example. And just like other stocks, ETFs must register with the Securities and Exchange Commission (SEC) and receive approval to issue a fixed number of shares.

Because a limited number of shares trade and they’re priced by the market itself, it’s possible for ETF shares to trade at a premium or discount to NAV.

ETFs control premiums and discounts through their share creation process. For every ETF, institutional investors can buy a basket of the same securities the fund already holds. They then give that basket to the fund in exchange for a creation unit, which typically represents anywhere from 50,000 to 100,000 shares of the ETF.

The process is reversed for redemptions: Institutional investors present a creation unit to a fund for which it receives the underlying basket of securities.

When ETFs trade at discounts to NAV, institutional investors will redeem creation units; when they’re at a premium, they’ll have creation units issued.

This process usually keeps the market value of ETFs fairly close to NAV, but things can–and sometimes do–go wrong.

United States Natural Gas Fund (NYSE: UNG), the largest ETF trading in that commodity, ran into problems when it ran out of issuable shares in early July.

A month prior to that, the fund had applied to register a billion new shares, but the SEC has been slow to approve the request because the Commodity Futures Trading Commission was reviewing its position limits.

Shares quickly ran up to an almost 3 percent premium to NAV. As of press time, the fund still hadn’t received SEC approval to issue additional shares.

This type of situation, although it obviously happens, is rare. ETFs are a solid option for investors and in fact offer many advantages.

For starters, mutual funds simply aren’t built to trade. Investors will often seek to exploit short-term trends in individual sectors, but many of the hundreds of sector-focused mutual funds carry redemption fees that can run as high as 2 percent if you hold them for less than 90 to 180 days.

That’s a big chunk of any potential gain, and many funds have “frequent trader” policies that could lock you out if you make too many roundtrips in a defined period. As the “exchange traded” part of the name implies, ETFs don’t bear such restrictions.

Investors putting large chunks of money to work at once would likely benefit from ETFs as well. If you’re putting a lot of cash into the market at once, one commission charge on an ETF transaction can be a much cheaper option than ringing up sale loads with your broker.

If you’re dollar-cost averaging over a long period of time, a mutual fund is likely a better option, particularly if you enroll in an automatic investment plan. No matter how cheap your commission may be, if you have to pay every time you add to a position, costs add up quickly.

Another advantage is that unlike most mutual funds, ETFs don’t have minimum purchase requirements. The only restrictions on purchase size are those set by your broker; some discount brokers actually allow you to buy fractional shares. But if you make use of a discount broker, buying ETFs in small lots can become extremely expensive.

Regardless of whether you’re an established mutual fund investor or if you’re just starting out, ETFs can be employed in tandem with your current strategies.