Exchange-Traded Fund (ETF) Definition
What Is an ETF?
Exchange-traded funds (ETFs) are a basket of securities that track the performance of stock market benchmarks such as the Dow Jones Industrial Average or the S&P 500.
ETFs trade just like stocks and bonds, which means investors can buy and sell shares throughout the trading day. That can impact the share price on the upside and downside. Low fees are a hallmark of ETFs.
ETFs have grown popular over the more than two decades because they’re cheaper than mutual funds, more tax-efficient, and easy to buy and sell.
The first U.S. based ETF splashed on the scene in 1993 when State Street Global Advisors launched the Standard and Poor’s Depositary Receipts (SPDR). The ETF tracks the performance of the S&P 500 and today remains the largest and most traded ETF in the world with close to $255 billion in assets under management. Three years after the SPDR’s debut, the first international ETF launched and in 2002 the first bond ETF was made available in the marketplace.
Over the past twenty-seven years, the number of ETFs has grown as has the assets under management. Today investors can find an ETF that covers pretty much every asset class whether its equities or real estate. ETFs have more than $4 trillion in assets under management and if Bank of America’s projection proves true will swell to $50 trillion in AUM by 2030.
History of ETFs
Prior to the launch of the first ETF in the early 1990s, index investing was all the rage. But the high cost, low volume, and minimum investment requirements shut regular investors out. With interest in indexing high, the fund companies set out to create low-cost passive index funds they can bring to the masses. In 1993 that became a reality when State Street Global Advisors launched the first U.S. ETF, the Standard and Poor’s Depositary Receipts (SPDR). The ETF tracks the performance of the S&P 500. Renamed in August of 2017, the SPDR S&P 500 ETF is still the largest and most traded ETF in the world with close to $255 billion in assets under management. In 1996, three years after the debut of SPDR, the first international ETF launched. It took six more years before the first bond ETF hit the market in 2002.
It wasn’t long after the debut of SPDR that other fund companies got into the ETF game. During the late 1990s and early 2000s, several different ETFs were created tracking everything from the Russell 3000 to U.S. Treasury bonds.
Despite the growing choices, it wasn’t until after the Great Recession of 2008 and 2009 that ETFs took off driven by a preference for passive, cheap investing. Many investors saw their life savings disappear and no longer saw value in paying more for actively managed funds. In 2008 ETFs had $531 billion in assets under management, today that stands at more than $4 trillion. According to Bank of America, the ETF market is poised to hit $50 trillion in assets by 2030.
Today there are thousands of ETFs tracking every asset class. The most popular ETFs track equities, fixed income, commodities, currency, real estate, and niche investments. BlackRock, Vanguard, and State Street by far are the dominant players in the ETF market. BlackRock’s iShares is in the lead with 39% market share, while Vanguard is in second controlling 25% of the market, and State Street is in third place accounting for 16% share. That’s not to say rivals like Charles Schwab and Fidelity Investments aren’t trying to chip away at that dominance.
Despite the huge growth, ETFs remain less popular than their mutual fund counterparts, which have about $18 trillion in total assets.
Why ETFs Are So Popular
The low-cost nature of ETFs is a top reason why they’ve resonated with investors in good and bad times. The expense ratio on ETFs is 0.2%; for mutual funds, it’s 0.55%, according to the Investment Company Institute. There’s no minimum investment required to own shares of an ETF, removing another barrier for regular investors.
Mutual funds investors are all too familiar with the tax hit they’re on the hook for when a fund manager buys and sells stocks. If there’s gains from any stock sales it can trigger a tax event. The higher the turnover the more tax exposure. That doesn’t happen as often with ETFs. ETFs are passive, tracking an index, which means less turnover and taxable events.
ETFs are also attractive to everyday investors because of the ease of buying and selling them. You can build or unload a position in an ETF in near real-time. Since they trade like stocks, investors can employ trading strategies such as shorting and buying on margin with ETFs. ETFs can give investors diversification if they spread their investment dollars across different funds.
That’s not to say ETFs aren’t without risk. Specialty ETFs that track a specific sector like airlines or telecommunications are more volatile than those tracking the S&P 500. Sector ETFs tend to be subject to changes in the stock market and may not be suitable for risk-averse investors.
ETF Fee Wars
Over its twenty-seven-year history, ETFs have seen a precipitous drop in expense ratios spurred on by intense competition and market dynamics. Take the Department of Labor’s expansion of the fiduciary rule in 2016, requiring brokers to adhere to the same standards as advisors. Aiming to take advantage of the shift toward ETFs, asset managers began including them in client’s portfolios in a big way, prompting funds to slash fees to get their business.
With so much demand the three leaders BlackRock, State Street, and Vanguard have stumbled over each other to slash fees, bringing expense ratios lower and lower. As the ETF market saw more entrants, expense ratios decline further with the average hovering around 0.2% as of the summer of 2020. A handful of fund companies have rolled out zero-fee ETFs in recent months but they’ve failed to take off with the masses.
How ETFs Have Evolved
ETFs have gotten advanced over the years and now include actively managed ETFs and several different bond funds. Actively managed ETFs employ a fund manager who manages the benchmarks the fund tracks. They have lower expense ratios than actively managed mutual funds but cost more than traditional ETFs. Actively managed ETF fund managers tend to work hard to prove their worth.
Bond ETFs invest in different fixed income securities including treasuries and corporate bonds. Just like bond mutual funds investors get exposure to different types of fixed income with varying maturities.
ETFs During the COVID-19 Pandemic
ETF demand tends to surge during times of uncertainty and that couldn’t be truer during the COVID-19 pandemic. With stock markets whipsawing between steep losses and gains investors turned to ETFs as a defensive play amid the early days of the pandemic. In the first week of March 2020, Fidelity Investments found trading volume hit a record $1.4 trillion in the U.S. and by the end of the month accounted for around 37% of all trading activity on the stock market. The interest in ETFs has continued unabated since then. In the first half of 2020 more than $200 billion was invested in ETFs and that’s with stocks in a bear market territory, CFRA Research found.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.