8/7/2019 [Investopedia] ETFs- How Did We Live Without Them

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ETFs: How Did We Live Without Them?

Exchange-traded fund (ETF) products exploded onto the scene in 1993 and

continued to gain momentum. These products have a number of benefits,including tax efficiency, cost structure and trading flexibility, to name afew. But, how did these products come to market? What prompted theirarrival? Will they stick around? And however did we live without them? Thisarticle will explore the origins of the ETF market and take a peek at what's tocome.

Initial Product Launch

On January 29, 1993, State Street Global Advisors, in partnership with the

American Stock Exchange, launched the first ever exchange-traded fund(ETF) in the United States. The ETF was launched under the name SPDR 500,ticker symbol SPY, and aimed to track the S&P 500 Index. With the success of SPY, other companies soon followed suit, developing similar products such asthe Dow Diamonds (DIA), launched on January 20, 1998, PowerShares QQQ (QQQQ) launched on March 10, 1999, and hundreds of others since then.

According to the Investment Company Institute, by the end of 2006, the totalnumber of ETFs in the market had grown to 359, with total assets at nearly$423 billion and an expected upward growth trend. But the original SPDRs,pronounced "spiders", have by far remained king among ETFs, with totalassets of more than $75 billion dollars as of February 29, 2008. (For related

reading, see What is a spider and why should I buy one?)

In the chart below, you can see the exponential growth of ETFs in themarketplace. It is expected that the ETF market will expand to more than $1trillion by the year 2010, according to projections from the Financial ResearchCorp. in Boston. (For more insight, check out  Advantages Of Exchange-Traded Funds.)

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 Year

Total

Broad-BasedDomesticEquity

Sector/IndustryDomesticEquity

Global/International Equity

Bond

Registered

Non-Registered*

1993

1 1 - - - 1 -

1994

1 1 - - - 1 -

1995

2 2 - - - 2 -

1996

19 2 - 17 - 19 -

1997 19 2 - 17 - 19 -

1998

29 3 9 17 - 29 -

1999

30 4 9 17 - 30 -

2000

80 29 26 25 - 80 -

2001

102 34 34 34 - 102 -

2002

113 34 32 39 8 113 -

2003

119 39 33 41 6 119 -

2004

152 60 43 43 6 151 1

2005

204 81 68 49 6 201 3

2006

357 133 133 85 6 343 14

Figure 1: Number of ETFs, investment objective and legalstructure, 1993-2006.*ETFs not registered under the Investment Company Act of 1940

Source: Investment Company Institute and Strategic InsightSimfund

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Academic Ties

 The mutual fund and ETF marketplace have greatly benefited from theinvestment principles borne in academic circles. Theories once limited to theivory towers of educational institutions have gained great support andinterest among commercial investment circles. For example, modern portfolio 

theory suggests that building a portfolio of multiple asset types can loweryour risk while preserving or boosting returns. Asset allocation studies laterconcluded that choosing the proper asset mix of stocks and bonds is moreimportant than picking individual stocks and bonds. The academic theory listcan go on, but these examples go to show how asset class investing, index fund investing, etc. all had academic foundations that helped fuel aninvestment industry focused on asset class. (For more on this, read Modern Portfolio Theory: An Overview.)

Market Demand

At first, ETFs were primarily marketed to institutional investors for hedging,transition management, tax-loss harvesting, sophisticated sector positioningand for "equitizing" cash (the strategy of taking a given amount of cash,turning it into an equity position and still retaining cash-like liquidity). But,according to the American Stock Exchange, by 2008 individual investorsaccounted for nearly half the total assets held in ETFs.

Market Shift

 This product's shift from institutional investor to individual investors can beattributed to two major trends in the industry. The first is the wide use of theinternet. With information, tools and education on different types of investments readily available online, individual investors have become awareof ETFs and their benefits, risks and costs.

 The second trend that has opened the doors for ETFs has been the migrationfrom commission-based financial advisors to fee-only financial advisors.Individuals are increasingly becoming more aware of the destructive effectsof exuberant costs, tax inefficiencies and heavy trading in their portfolios. Assuch, they are demanding change in the way their money is managed. Manyinvestors are hiring fee-only advisors to allocate their assets and many of 

these advisors are using ETFs in their portfolio strategies. Why buy 20individual stocks and pay the commissions plus the trading costs when youcan buy one ETF that already owns those securities and gives you broadexposure o the market? The more an investor saves on portfolio costs, themore is available for direct investment to fund future gains. (For more insight,read 3 Steps To A Profitable ETF Portfolio.)

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How Do ETFs Compare to Mutual Funds?

ETFs are cousins of mutual funds. Let's start our comparison by naming twobenefits directly associated with the diversification of your portfolio. Forstarters, ETFs do not have fund minimums like most mutual funds do. This isimportant because minimums can create a barrier to developing an efficient

and well diversified portfolio. It can be very tricky to diversify a small portfoliowhen the fund minimums prohibit you from buying more than five mutualfunds. However, when using ETFs, you have to consider trading costs if youare implementing a dollar-cost averaging strategy. Competition betweenbrokerages tends to reduce this problem.

Another benefit to ETF investors as it relates to asset allocation within thefund portfolio is that there is no cash drag. This refers to the cash that amutual fund carries to meet redemptions or use on investment opportunities.

 This affects performance because the mutual fund is not fully invested.

Because ETFs are bought and sold over the exchanges, there's no cash flowfor a fund manager to worry about. The fund remains fully invested in themarket. Mutual funds, on the other hand, have to keep a supply of cash onhand for redemptions and must invest incoming cash flows. There is verylittle return on cash, which puts a drag on the mutual fund's performance.

Another important benefit, especially for those who like to time the market, isthat ETFs trade intraday, just like stocks. You can buy or sell at a given pricethroughout the day and can set price limits. With mutual funds, on the other

hand, you buy at net asset value at the end of the day. What this means isthat if you see the market tanking at 11am and you decide to sell out, youcan sell your ETF at the price at which it is trading at that moment in time. Incontrast, if you sell a mutual fund and the market continues to go south, youwill receive the price at the end of the day. The same problem occurs whenthe market is going up. As such, ETFs give investor much more control overhow and when to trade.

Other benefits of using ETFs over mutual funds that are pretty self explanatory, including lower expense ratios, the ability to sell short, no sales

loads (usually) and sometimes tax efficiencies.

Asset Class Availability

As more investors became familiar with ETFs, ETF sponsors continued to offermore funds with different investment objectives. You can buy an ETF thattracks the entire index or a subset of the index. Some ETFs now track

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benchmarks that are adjusted and weighted by dividend yield or otherfundamental factors. There are also ETFs with bear market strategies, whichallow investors to profit from market downturns by shorting the indexes. Thiscan be a great choice for investors with retirement accounts that can't shortindividual stocks. There are also ETFs that specialize in certain sectors likecurrencies, commodities and metals. (For further reading, check out ETFs 

Provide Easy Access To Energy Commodities.)

 There are also riskier ETFs for the more speculative type of investors. TheUltra ETFs, for example, aim to increase the exposure to the indexes andprovide investors with double the daily performance of the index - this canalso mean double the losses.

Let's take a look at the ETF landscape in 2007 and 2008.

ETF Type January2008

December2007

 January2007

 Total Domestic Equity Index 370,001 393,953 295,838• Domestic (Broad

Based) 274,190 300,930 233,935

• Domestic(Sector/Industry) 95,811 93,023 61,903

Global/International EquityIndex

160,862 179,702 114,292

Hybrid Index 119 119 -

Bond Index 37,743 34,648 20,949

All 568,725 608,422 431,078Source: Investment Company Institute

Conclusion The birth of the ETF in 1993 provided investors with what we now call a blendbetween a stock and a mutual fund. Any tools that help the investor improveportfolio efficiencies and costs are a bonus. There are many great reasons toinclude ETFs in your portfolio; just remember to take into consideration youroverall investment strategy, risk tolerance and portfolio costs. We can expectthat many more ETFs will enter the market, which should provide investorsand advisors with the opportunity to enter markets previously unavailable orcostly to small investors.