A Brief History of Exchange-Traded Funds

As an investor, you have more choices than ever for how to put your money to work in the markets. You can access thousands of individual stocks, mutual funds, and other instruments. One of the options available to you is the exchange-traded fund, or ETF.

ETFs have only been around since 1990 but have quickly become one of the most popular investment instruments. They offer the diversity of a mutual fund but trade like a stock. ETFs have opened up the markets to many new investors and strategies. However, understanding ETFs and how they can benefit your portfolio helps you understand their origins and brief but impactful history.

The Origins of ETFs: How It All Began

The first exchange-traded fund (ETF) was launched in 1990 in Canada, introducing a new investment instrument that provided intraday liquidity and lower fees than mutual funds.

The SPDR S&P 500 ETF

In 1993, State Street Global Advisors introduced the SPDR S&P 500 ETF Trust (nicknamed “the Spider”), the first ETF in the U.S. It tracks the S&P 500 stock market index. Investors can buy and sell shares of the Spider throughout the day on stock exchanges, just like individual stocks.

  1. Low Fees: ETFs typically have lower fees than mutual funds because most are passively managed, simply tracking an index. The Spider charges just 0.09% annually.
  2. Tax Efficiency: ETFs can be more tax efficient than mutual funds. When a mutual fund sells securities, it often realizes capital gains that are passed on to shareholders. ETFs typically only realize capital gains when an investor sells shares.
  3. Intraday Liquidity: Unlike mutual funds priced once a day after markets close, ETFs can be traded throughout the day on exchanges, allowing investors to react quickly to market changes.

The launch of the Spider introduced a groundbreaking new investment product and started the multi-trillion-dollar U.S. ETF industry. It gave investors an inexpensive, tax-efficient, and liquid way to invest in the stock market. Over 25 years later, the Spider remains one of the most popular ETFs, with over $470 billion in assets.

Related: Hidden Concerns of ETF Investments: What Every Investor Needs to Know

The First ETFs Hit the Market in the 1990s

The first exchange-traded funds (ETFs) were launched in the 1990s, allowing investors to trade funds on stock exchanges much like stocks.

Growth of the ETF Market

The success of SPY led to the creation of more ETFs tracking popular indexes. ETFs grew rapidly in the early 2000s by offering low fees, tax efficiency, and transparent holdings. Providers introduced ETFs covering sectors, countries, commodities, and alternative assets.

New Options for Investors

The rise of ETFs gave investors more choices and flexibility. They could easily invest in specialized areas or hedge risks. ETFs also opened up strategies like passive investing, tactical asset allocation, and risk-parity portfolios.

As the number and variety of ETFs grew, they empowered investors with more options and control over their portfolios. Today’s ETF landscape exposes nearly every asset class and sector, allowing for precise investing and risk management. ETFs have revolutionized how individuals and institutions invest in the last 30 years.

ETF Growth and Proliferation in the 2000s

In the early 2000s, ETFs started gaining mainstream popularity and saw rapid growth. From 2000 to 2010, the number of ETFs listed in the U.S. grew from 80 to around 1,000, and assets under management increased from $74 billion to $1 trillion. Investors became attracted to ETFs for their low fees, tax efficiency, and trading flexibility compared to mutual funds.

Several factors drove the expansion of ETFs during this period. In 2000, Barclays Global Investors launched some of the first bond ETFs, introducing fixed-income ETFs to investors. In 2001, Vanguard entered the ETF market, signaling to investors that ETFs had become a mainstream investment option. Vanguard helped popularize low-cost ETFs, with its first ETF charging an expense ratio of only 0.12%.

In the mid-2000s, ETF providers began offering ETFs in new asset classes like commodities, real estate, and emerging markets. These new ETFs give investors more tools for asset allocation and diversification. In 2006, the first leveraged and inverse ETFs were introduced, allowing sophisticated investors to gain magnified exposure or hedge risks.

The financial crisis of 2008 led to even greater interest in ETFs. Investors fled risky and expensive financial products in favor of the transparency and lower costs of ETFs. By the end of the decade, almost every asset class had ETF options, including alternatives like infrastructure, timber, and water. ETF fund flows set new records, and total ETF assets reached $1 trillion.

The 2000s established ETFs as investments for retail and institutional investors. Their expansion into new asset classes and investment strategies paved the way for future growth. The proliferation of ETFs in this era marked a turning point, where they evolved from a niche product into a dominant force that would reshape the investment landscape.

Recent ETF Innovations and Trends

Recent years have seen significant innovations in ETFs that provide investors with more options and flexibility.

Actively Managed ETFs

Actively managed ETFs differ from traditional ETFs that track an index. Active ETFs are managed by portfolio managers who buy and sell holdings to try and outperform the overall market. Actively managed ETFs provide the tax efficiency and traceability of ETFs, but with the potential for higher returns from active management.

Inverse and Leveraged ETFs

Inverse and leveraged ETFs are designed to amplify the returns of an index. Inverse ETFs track the opposite of an index’s performance. Leveraged ETFs aim to double or triple the return of an index. These ETFs use derivatives and debt to amplify returns and are rebalanced daily. They come with additional risks, like volatility reduction, and are suitable only for short-term trading.

Thematic ETFs

Thematic ETFs invest in companies related to a specific theme or trend, like cloud computing, fintech, or artificial intelligence. They provide exposure to fast-growing trends and technologies. However, they tend to be riskier since the companies are often smaller, and the themes can change quickly. Examples of thematic ETFs include the Global X Robotics & Artificial Intelligence ETF (BOTZ) and the ARK Fintech Innovation ETF (ARKF).

Halal ETFs

A Halal Exchange-Traded Fund (ETF) is an investment fund that adheres to Islamic Shariah law and is designed for Muslim and ethical investors. It tracks an index, commodity, bond, or asset basket, trading like a stock with benefits like real-time pricing and lower fees. To be Halal, an ETF undergoes stringent screening:

  1. Business Activity: It excludes companies earning significantly from non-Halal sources like interest, gambling, alcohol, pork, tobacco, specific marijuana sectors, and adult entertainment. An ETF is Shariah-compliant if less than 5% of its revenue comes from these activities.
  2. Interest-bearing Securities and Assets: Since earning from interest is prohibited in Islam, a Halal ETF can’t include companies with significant interest-bearing investments. The limit is 30% of the ETF’s market capitalization over 36 months.
  3. Interest-bearing Debt: Companies in the ETF should have minimal interest-based debt, under 30% of their market capitalization, aligning with the Islamic prohibition of “Riba” (interest).

Halal ETFs offer a compliant investment avenue for those following Islamic principles and ethical investing standards.

Read: Best Halal ETFs to Invest in 2023

The Future of ETFs: Where Are They Headed Next?

The future of ETFs looks bright. As investors continue to seek low-cost, tax-efficient investment vehicles, ETFs are poised for tremendous growth.

Growing Product Offerings

Today, investors can access ETFs covering nearly every asset class, sector, and niche. This trend will likely accelerate as issuers race to fill gaps in the ETF universe. We will see more actively managed ETFs, leveraged and inverse ETFs, and ETFs with non-traditional strategies.

Increased Adoption

ETFs have gained mainstream popularity but still comprise a minority of total invested assets. As more investors discover their benefits, ETFs will capture a greater share of investment portfolios. Financial advisors and institutions are also increasing their use of ETFs.

Global Expansion

While still concentrated in the U.S. and Europe, the ETF market is expanding into Asia, Latin America, and other regions. Local exchanges launch their ETF platforms, and international ETF issuers are tailoring products to specific countries and regions. ETFs provide convenient access to global markets, so their growth potential is significant.

Technological Innovation

Advances in financial technology will drive further ETF innovation. “Smart beta” ETFs that use quantitative analysis and rules-based indexes are one example. Blockchain and crypto assets are other areas that may impact ETFs. As technology transforms investing, ETFs will likely remain at the forefront of product development.

Read: Do ETFs Pay Dividends?

Bottom Line

And so it is that ETFs have revolutionized investing for individuals and institutions alike. No longer are people limited to buying individual stocks; now, entire indexes and sectors can be purchased with a button. Fees have plummeted, diversification has skyrocketed, and trading has become remarkably simplified.

The ETF industry continues introducing new and innovative products at a breakneck pace to meet market demands. While the future remains uncertain, one thing is clear: ETFs have democratized investing and become a crucial tool for building wealth in the 21st century. The history of these funds highlights how innovation, competition, and a desire to improve lives can transform an industry and change the world.

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