Last Updated on 10 February, 2024 by Abrahamtolle
Have you ever wondered how ETFs came into existence? Exchange-traded funds (ETFs) have become increasingly popular in recent years, but their history goes back to the early 1990s. The first ETF was introduced as a way for investors to gain exposure to a variety of asset classes without having to purchase individual stocks or bonds. Today, ETFs are a popular form of index investing and passive investing, providing investors with easy access to diversified portfolios. Some ETFs also invest in futures, while others are structured as unit investment trusts.
State Street Global Advisors launched the first ETF, the SPDR S&P 500, in 1993. This new investment vehicle allowed investors to trade index participation shares throughout the day on an exchange. It was similar to an index fund but had more flexibility as it could be bought and sold like a stock. Since then, popular ETFs such as commodity ETFs, leveraged ETFs, and bond ETFs have been introduced to provide investors with more diverse investment options.
Today, there are thousands of ETFs and index funds available, covering a wide range of asset classes such as stocks, bonds, and even inverse ETFs. iShares by BlackRock and Vanguard are among the largest issuers of ETFs and index funds. With free trading options available for many ETFs and unit investment trusts, they have become a popular choice for both retail and institutional investors interested in index investing. Mutual fund investors may also find ETFs and index funds appealing due to their low expense ratios and diversification benefits.
In this article, we’ll explore the history of ETFs and their relation to index investing and index funds in more detail. We’ll also answer questions like “How do ETFs work?” and “Where can you find them listed on a stock exchange?” Additionally, we’ll touch on how ETFs differ from mutual funds. Let’s dive in!
The Origins and Early Development of ETFs
First ETF: A Revolutionary Investment Tool
The first-ever Exchange Traded Fund (ETF) was introduced in the US in 1993. State Street Global Advisors launched the Standard & Poor’s Depositary Receipts (SPDRs), which is now commonly known as SPY. This innovative investment tool offered investors a new way to gain exposure to the stock market by tracking the underlying securities of an index. Today, popular ETFs include commodity ETFs, leveraged ETFs, and bond ETFs.
Development of ETFs: A Game-Changing Innovation
ETFs were developed as a hybrid product that combined features of mutual funds and individual stocks. Unlike mutual funds, ETFs are traded like stocks on exchanges throughout the day, such as NYSE, while their prices fluctuate with market demand and supply. Like mutual funds, they allow investors to diversify their portfolios across various asset classes, sectors, and geographic regions, including underlying securities and commodities futures.
One crucial development in ETFs and index funds is the creation unit mechanism used to create new shares. Creation units are large blocks of shares that authorized participants can buy or redeem directly from an ETF issuer in exchange for cash or basket of underlying securities. This allows them to create or redeem shares at net asset value (NAV) without affecting the price of individual shares traded on exchanges such as NYSE. Mutual fund investors can also benefit from this mechanism, especially those investing in 2x funds.
Europe Joins The Party
Europe saw the creation of its first ETF in 2000 when iShares launched its FTSE 100 tracker fund on the London Stock Exchange (LSE). Since then, Europe has become a significant player in the global ETF industry, with over $1 trillion assets under management( AUM) spread across more than 2,000 products, including index ETFs, index funds, leveraged ETFs, and commodity ETFs.
Growing Popularity Over The Years
Over time, ETFs have gained popularity among investors due to their low cost, tax efficiency, transparency, flexibility, and ease of trading on the stock exchange compared to traditional investment vehicles such as mutual funds or hedge funds. ETFs are also considered securities and futures that can be traded on the NYSE.
According to data from Statista Research Department, global assets invested in exchange-traded funds (ETFs) and securities amounted to approximately 8.6 trillion U.S. dollars as of June 2021, up from around 2.7 trillion U.S dollars in 2015. The futures market and NYSE also saw significant growth during this period. Additionally, investors have been attracted to ETFs due to their tax efficiency compared to other investment vehicles.
Growth and Expansion of ETFs: From Niche to Mainstream
ETFs Have Grown from a Niche Investment Product to a Mainstream Option for Investors
Exchange-traded funds (ETFs) have come a long way since their introduction in 1993. Initially, they were considered niche investment products with limited appeal. However, over the years, they have grown in popularity and become mainstream investment options for investors worldwide. ETFs are securities listed on NYSE and trade like stocks. They offer exposure to a diversified portfolio of underlying assets such as futures contracts and are priced based on their net asset value.
Today, ETFs and index funds are two of the fastest-growing segments of the financial market. According to data from Statista, global assets under management (AUM) for ETFs and index funds amounted to $4.7 trillion as of May 2021. This represents an increase of more than 500% from $700 billion in AUM at the end of 2007. Mutual funds, stock exchanges, and securities also play a significant role in this growth.
One reason for the growth of ETFs is that they offer several advantages over traditional mutual funds and individual stocks. For example, ETFs provide investors with diversification benefits by allowing them to invest in a broad range of sectors and commodities without having to buy individual securities. Additionally, ETFs are traded on the NYSE, making it easy for investors to buy and sell shares. Moreover, ETFs track various indices, which can help investors monitor the performance of their investments. Lastly, ETFs have a transparent net asset value, which allows investors to see the underlying value of their investment.
ETFs, classified as securities, offer greater liquidity than traditional mutual funds, making them an attractive option for tactical allocation strategies. Moreover, because they trade on stock exchanges like individual stocks such as NYSE, investors can buy or sell shares throughout the trading day at market prices. ETFs are designed to track indices and their net asset value.
The NYSE Was the First Stock Exchange to List an ETF in 1993
The first-ever exchange-traded fund was created by State Street Global Advisors and listed on the New York Stock Exchange (NYSE) in January 1993. Known as SPDR S&P 500 Trust (SPY), it tracks the performance of the S&P 500 index and remains one of the most actively traded ETFs today. This security offers investors a share in the net asset value of the underlying indices.
Since then, the NYSE and many other stock exchanges around the world have followed suit and launched their own ETF listings. These ETFs track various securities and indices, including the popular 2x fund. In Europe alone, there are now over 2,000 different types of ETFs available across various exchanges.
The growth of ETFs has also led to the creation of new securities products that provide investors with exposure to previously inaccessible stock exchange markets such as NYSE. For example, investors can now invest in ETFs that track specific sectors such as technology or healthcare, or commodities such as gold or oil, and buy shares in them.
Institutional Investors Have Been Key Drivers of ETF Growth
Institutional investors, including those trading securities on the NYSE, have been key drivers of ETF growth, accounting for a significant portion of net inflows into these funds in recent years. According to data from BlackRock, institutional investors accounted for over 60% of total net inflows into global ETFs in 2020, contributing to the share value of these funds.
One reason why institutional investors are attracted to ETFs is because they offer greater flexibility and cost-efficiency than traditional mutual funds. For example, many institutional investors use ETFs as part of their portfolio hedging strategies because they provide exposure to a broad range of securities at a lower cost than buying individual stocks. Additionally, ETFs can be traded on the NYSE like shares, allowing investors to easily buy and sell them based on their perceived value.
ETFs, which are securities traded on the NYSE, have also become popular among retail investors who are looking for low-cost investment options that offer diversification benefits. As more retail investors enter the market, the demand for ETFs and their share value is likely to continue growing.
Advantages of ETFs over Mutual Funds
Lower Costs and Fees
One of the significant advantages of ETFs over mutual funds is their lower costs and fees. Unlike mutual funds, ETFs trade on an exchange like securities, such as the NYSE, which means they have lower operating expenses. The share value for ETFs is generally much lower than that for mutual funds. This makes them more attractive to individual investors who want to keep their investment costs down.
Moreover, index ETFs, commodity ETFs, leveraged ETFs, and inverse ETFs shares can be bought and sold throughout the day at market prices. This allows investors to make trades at any time during trading hours without having to worry about being charged a fee for each transaction. In contrast, mutual fund transactions are usually processed once a day after the market closes, which means that investors may miss out on opportunities or have to pay higher fees.
Greater Flexibility in Asset Allocation
ETFs offer greater flexibility in asset allocation compared to mutual funds. They allow investors to choose from a wide range of securities and fixed income options that suit their investment goals and risk tolerance levels. For example, there are income ETFs that focus on high-yield bonds or dividend-paying stocks, as well as 2x funds that provide leveraged exposure to specific sectors or indices. Investors can easily buy and sell shares of ETFs throughout the trading day, making it easier to adjust their portfolio according to market conditions.
There are different types of ETF structures available, such as investment trusts and unit investment trusts (UITs), each with unique features that cater to different investor needs. This flexibility allows investors to customize their portfolios according to their preferences while still maintaining diversification. Additionally, index ETFs provide exposure to a specific market index, while leveraged ETFs use borrowed funds to amplify returns. Investors can also purchase shares of ETFs for easy trading on the stock exchange.
Reliability Through Arbitrage Mechanism
The arbitrage mechanism used by ETFs helps ensure that their net asset value (NAV) stays close to the market price, making them a more reliable investment option than mutual funds. When an ETF’s market price deviates from its NAV due to supply and demand imbalances or other factors, authorized participants (APs) step in to buy or sell the underlying assets until the discrepancy is eliminated.
This process helps keep the ETF’s market price in line with its NAV, which provides investors with a more accurate reflection of the fund’s underlying value. In contrast, mutual funds are priced once a day based on their NAV, which may not accurately reflect the current market conditions. Index ETFs and leveraged ETFs also benefit from this pricing mechanism.
Types of ETFs Available Today
One of the most popular types of ETFs available today are equity ETFs. These funds track a specific stock index or sector, providing investors with exposure to a broad range of companies within that index or sector. For example, an investor could purchase an S&P 500 ETF, which would provide them with exposure to the 500 largest publicly traded companies in the United States. Equity ETFs are a great way for investors to gain diversified exposure to the stock market without having to pick individual stocks.
Fixed Income ETFs
Another type of ETF available today is fixed income ETFs. These funds track bonds or other debt securities, providing investors with exposure to fixed income assets like corporate bonds and treasury bonds. Fixed income ETFs can be a great addition to any portfolio, as they provide diversification benefits and can help reduce overall portfolio risk.
Commodity ETFs are another popular type of fund available today. These funds provide investors with exposure to physical commodities like gold, silver, oil, and agriculture products. By investing in commodity ETFs, investors can benefit from price movements in these markets without having to physically own the underlying commodities themselves.
Finally, currency ETFs are another type of fund available today that provides investors with exposure to foreign currencies. Investing in currency ETFs can be a great way for investors to hedge against currency risk or take advantage of movements in foreign exchange rates.
Overall, there are many different types of ETFs available today that cater to a wide variety of investment strategies and goals. Whether you’re looking for broad market exposure through equity or fixed income funds or more specialized investments like commodity and currency funds, there’s likely an option out there that fits your needs.
Some examples of popular Indian-based ETFS include Nifty 50 Index Fund (ICICI Prudential), Reliance Mutual Fund, and Kotak Sensex ETF. In terms of the largest ETFs globally, as of 2021, the top three are the SPDR S&P 500 ETF Trust, iShares Core MSCI EAFE ETF, and Vanguard Total Stock Market ETF.
Criticisms and Challenges Faced by ETFs
Passive Investment Strategy Increases Market Volatility
ETFs have been criticized for increasing market volatility due to their passive investment strategy. Unlike actively managed funds, which aim to outperform the market, ETFs track an index or a basket of securities. This means that when investors buy or sell shares of an ETF, the underlying securities are also bought or sold in proportion to their weighting in the index. As a result, large inflows or outflows from ETFs can cause significant price movements in the underlying securities.
For example, if a popular tech stock represents a large portion of an index being tracked by a leveraged ETF and investors suddenly start selling shares of the ETF, it could trigger a chain reaction of selling in the tech stock as well. This could lead to a sharp decline in its price and potentially even trigger a broader market sell-off.
Possibility of Market Crash
Some experts believe that ETFs may lead to a market crash if investors panic and sell their shares simultaneously. Since ETFs trade on exchanges like stocks, they are subject to market forces such as supply and demand. If investors suddenly start selling shares of an ETF en masse, it could trigger a downward spiral in prices that could spread throughout the entire market.
This scenario is known as “liquidity mismatch,” where there may not be enough buyers for all the sellers during times of stress. Critics argue that this risk is amplified by the fact that many investors hold similar positions in popular ETFs, which can exacerbate selling pressure during times of crisis.
Lack of Transparency
Critics argue that ETFs do not provide enough transparency as they may hold securities that are not disclosed to investors. While most ETFs disclose their holdings on a daily basis, some specialized funds may only disclose their holdings quarterly or even annually. This lack of transparency can make it difficult for investors to fully understand what they are investing in and the risks associated with those investments.
Furthermore, some ETFs may use complex derivatives or leverage to enhance returns, which can add an additional layer of risk that may not be apparent to investors. This lack of transparency has raised concerns among regulators who worry that investors may not fully understand the risks associated with these products.
Promoting Short-Term Trading
ETFs have also been accused of promoting short-term trading, which can be detrimental to long-term investors. Since ETFs trade like stocks, they are subject to the same market forces as individual securities. This means that investors can buy and sell shares of an ETF throughout the day, potentially taking advantage of short-term price movements.
While this may be attractive to some traders looking for quick profits, investing in leveraged ETFs or index ETFs can be harmful to long-term investors who may be tempted to make impulsive decisions based on short-term market fluctuations. Furthermore, frequent trading of ETF shares can lead to higher transaction costs and taxes, which can eat into investment returns over time. It is important to carefully consider ETF inflows and outflows before making any investment decisions.
Concentration of Market Power
The growth of ETFs has raised concerns about the concentration of market power in the hands of a few large asset managers. As more money flows into passive investment strategies like ETFs, a handful of firms have come to dominate the industry. For example, BlackRock and Vanguard together manage over $7 trillion in assets, much of it in low-cost index funds and ETFs.
Critics argue that this concentration could lead to conflicts of interest and limit competition in the asset management industry, especially with the rise of leveraged ETFs and ETF shares. Furthermore, these large firms may have outsized influence over corporate governance issues since they often hold significant stakes in many companies through their index funds.
Popular ETF Providers and Their Offerings
BlackRock iShares is the biggest issuer of exchange-traded funds (ETFs) globally, with over 900 funds in its portfolio. The company offers a wide range of ETFs that cater to different investment objectives, including equity, fixed income, and alternative investments. Some of the popular iShares ETFs include the iShares Core S&P 500 ETF (IVV), which tracks the performance of the S&P 500 index; the iShares MSCI EAFE ETF (EFA), which provides exposure to developed markets outside North America; and the iShares Gold Trust (IAU), which invests in physical gold.
iShares has gained popularity among investors due to its low expense ratios and liquidity. The company’s flagship fund, IVV, has an expense ratio of just 0.03%, making it one of the cheapest S&P 500 index-tracking ETFs available. Many of BlackRock’s iShares funds trade with high volumes on major exchanges worldwide, providing investors with easy access to buy or sell shares.
Vanguard: A Popular Choice for Low-Cost Index Funds
Vanguard is another popular provider of exchange-traded funds known for offering low-cost index funds. With over $7 trillion in assets under management as of December 2020, Vanguard is one of the largest asset managers globally. The company offers over 80 ETFs across multiple asset classes such as equity, fixed income, and commodities.
One significant advantage that Vanguard offers is its low expense ratios compared to other providers. For example, their flagship fund – Vanguard Total Stock Market ETF (VTI) – has an expense ratio of only 0.03%. This means that investors can gain exposure to a diversified portfolio at a minimal cost, without the added expense of leveraged ETFs.
State Street Global Advisors: Creator Of The First-Ever ETF
State Street Global Advisors (SSGA) is the company that launched the first-ever ETF, SPDR S&P 500 (SPY), in 1993. The fund tracks the performance of the S&P 500 index and has become one of the most heavily traded securities worldwide. Apart from SPY, State Street offers over 200 ETFs covering various asset classes such as equity, fixed income, and commodities.
One of SSGA’s most popular offerings is the SPDR Gold Shares (GLD), which provides exposure to physical gold. The fund has become a favorite among investors looking to diversify their portfolio by investing in an asset with low correlation to traditional investments like stocks and bonds. However, if you’re looking for a more aggressive investment strategy, SSGA also offers a leveraged ETF option.
Invesco: A Diverse Range Of ETFs
Invesco is another major provider of exchange-traded funds known for offering a diverse range of products. The company offers over 240 ETFs that cover different asset classes such as equity, fixed income, and alternative investments. One of its popular offerings is the Invesco QQQ Trust (QQQ), which tracks the performance of the Nasdaq-100 index.
In addition to QQQ, Invesco offers several other innovative products that cater to specific investment objectives. For instance, Invesco Solar ETF (TAN) invests in companies engaged in solar power production and distribution globally.
Schwab: Commission-Free Trading And Over 20 ETFs
Schwab is a well-known provider of commission-free trading services for exchange-traded funds. The company offers over 20 proprietary ETFs covering various asset classes such as equity, fixed income, and alternative investments.
One of Schwab’s most popular offerings is Schwab U.S. Large-Cap ETF (SCHX). This fund aims to provide exposure to large-cap U.S.-based companies with low expense ratios compared to similar funds offered by competitors.
The Evolution and Importance of ETFs
ETFs have become popular due to their low costs, tax efficiency, and ease of trading.
ETFs or exchange-traded funds are a type of investment vehicle that allow investors to buy and sell a basket of assets in a single transaction. They have gained popularity over the years due to their low costs, tax efficiency, and ease of trading. Unlike mutual funds, which are priced at the end of the day, ETFs can be traded throughout the day like stocks. This makes them more liquid than mutual funds and allows investors to react quickly to market changes.
Another advantage of ETFs is that they are usually cheaper than mutual funds. Since they track an index rather than being actively managed by a fund manager, they have lower management fees. Since they do not need to buy or sell assets as frequently as mutual funds do, they also incur fewer transaction costs.
Furthermore, ETFs are generally more tax-efficient than mutual funds because they typically generate fewer taxable events. Mutual funds often distribute capital gains at the end of each year if they have sold securities for a profit during that year. In contrast, most ETFs use an “in-kind” creation and redemption process where authorized participants trade securities with the fund in exchange for shares. This process usually does not result in capital gains distributions.
The history of ETFs dates back to 1993 when State Street Global Advisors launched SPDR S&P 500 (SPY), which tracks the S&P 500 Index.
The first-ever ETF was created by State Street Global Advisors in 1993 when it launched SPDR S&P 500 (SPY), which tracks the S&P 500 Index. At that time, there were only three other index-based products available: futures contracts on stock indexes such as the S&P 500 and Russell 2000 indices; open-end index-mutual funds; and closed-end funds. SPY was created to address some of the limitations of these products, such as high fees and limited liquidity.
Since then, ETFs have evolved significantly. Initially, most ETFs were equity-based and tracked broad market indexes such as the S&P 500 or Dow Jones Industrial Average. However, today there are many ETFs that cover a wide range of assets such as bonds, commodities, and leveraged ETFs.
Leveraged ETFs use leverage to amplify returns but come with higher risks due to their high leverage ratio.
Leveraged ETFs are designed to amplify returns by using financial derivatives like futures contracts or swaps. They use leverage to increase the exposure of an index, commodity or currency pair beyond what is possible with a traditional non-leveraged ETF. For example, a 2x leveraged S&P 500 fund would aim to deliver twice the daily return of the S&P 500 Index.
While leveraged ETFs can provide investors with potentially higher returns than non-leveraged funds in certain market conditions, they also come with higher risks due to their high leverage ratio. This means that losses can be amplified just as much as gains when markets move against them.
Transparent ETFs have become an important investment vehicle for investors due to their ease of trading and low costs.
Transparent ETFs disclose their holdings on a daily basis so that investors know exactly what they own at any given time. This transparency has made them an important investment vehicle for investors who want exposure to specific sectors or asset classes without having to buy individual stocks or bonds.
One advantage of transparent ETFs is that they are easy to trade on exchanges throughout the day like individual stocks. This makes them more liquid than mutual funds and allows investors to react quickly to market changes. Since most transparent ETFs track an index rather than being actively managed by a fund manager, they have lower management fees compared with mutual funds.
ETF inflows have increased over time, indicating the growing popularity of these investment vehicles among investors.
ETFs have become increasingly popular among investors over the years, with assets under management (AUM) growing significantly. According to data from ETF.com, global ETF AUM reached $7.6 trillion in 2020, up from just $100 billion in 2000.
The Future of ETFs: Trends and Predictions
As we have seen in the previous sections, the history of ETFs has been a story of growth, innovation, and evolution. But what does the future hold for these investment vehicles?
Firstly, it is expected that the popularity of ETFs will continue to rise. With their low costs, flexibility, and transparency, more investors are likely to choose them over traditional mutual funds. This trend is especially true for younger generations who prefer digital platforms and self-directed investing.
Secondly, there will be an increase in thematic ETFs that allow investors to invest in specific sectors or themes such as renewable energy or healthcare. As investors become more socially conscious and aware of global issues, they are looking for ways to align their investments with their values.
Thirdly, there will be further advancements in technology that will make it easier for investors to access and trade ETFs. For example, blockchain technology could revolutionize how ETF trades are settled and cleared.
Lastly, regulatory changes may also impact the future of ETFs. As governments around the world tighten regulations on financial products and services, it remains to be seen how these changes will affect the growth and development of ETFs.
In conclusion, while we cannot predict the future with certainty, it is clear that ETFs have come a long way since their inception. With continued growth and innovation in this space, they are likely to play an increasingly important role in shaping investment portfolios going forward.
Q: Are all types of assets available as an ETF?
A: No. While most asset classes such as stocks or bonds can be offered as an ETF product type; some asset classes like real estate or private equity may not be accessible through an exchange-traded fund.
A: When you buy shares in an ETF, you are buying a portion of the underlying assets held by the fund. The value of your shares will rise and fall with the value of these underlying assets.
Q: Can I trade ETFs like individual stocks?
A: Yes. ETFs can be bought and sold throughout the trading day on exchanges, just like individual stocks.
Q: What is the difference between active and passive ETFs?
A: Active ETFs are managed by investment professionals who aim to outperform a benchmark index while passive ETFs track a specific index or asset class without any active management.
Q: Are there any tax advantages to investing in an ETF?
A: Yes. Because of their structure, most ETFs are more tax-efficient than mutual funds as they generate fewer taxable events such as capital gains distributions.
Q: Do all brokers offer access to all available ETFs?
Q: No. Different brokers may have different offerings based on their partnerships with various providers or market access restrictions. This includes leveraged ETF and ETF shares.
Q: Can I use leverage when trading an ETF?
A: Some leveraged and inverse ETF products exist that allow investors to amplify returns or take short positions; however, these types of products come with higher risks and are not suitable for all investors.
How do ETFs differ from traditional investment options like mutual funds?
Unlike mutual funds, ETFs are traded on exchanges throughout the day, offering more flexibility. They combine features of mutual funds and individual stocks, allowing investors to diversify their portfolios across different asset classes, sectors, and geographic regions.
What was the significance of the creation unit mechanism in the development of ETFs?
The creation unit mechanism, allowing the creation or redemption of shares at net asset value without affecting the market price, played a crucial role. It facilitated the creation of large blocks of shares by authorized participants, contributing to the growth of ETFs.
How have ETFs transformed from a niche to mainstream investment option?
ETFs provide lower costs and fees, greater flexibility in asset allocation. ETFs have grown exponentially since their introduction, becoming mainstream options for investors worldwide. Assets under management (AUM) for ETFs and index funds amounted to $4.7 trillion as of May 2021, showcasing their rapid growth.