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 a few. But, how did these products come to market? What prompted their arrival? Will they stick around? And however did we live without them? This article will explore the origins of the ETF market and take a peek at what's to come.

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 as the 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 total number 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 total assets 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 the marketplace. It is expected that the ETF market will expand to more than $1 trillion by the year 2010, according to projections from the Financial Research Corp. in Boston. (For more insight, check out Advantages Of Exchange-Traded Funds.)

Year	Total	Broad-Based Domestic Equity	Sector/Industry Domestic Equity	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 legal structure, 1993-2006. *ETFs not registered under the Investment Company Act of 1940

Source: Investment Company Institute and Strategic Insight Simfund

Academic Ties
The mutual fund and ETF marketplace have greatly benefited from the investment principles borne in academic circles. Theories once limited to the ivory towers of educational institutions have gained great support and interest among commercial investment circles. For example, modern portfolio theory suggests that building a portfolio of multiple asset types can lower your risk while preserving or boosting returns. Asset allocation studies later concluded that choosing the proper asset mix of stocks and bonds is more important than picking individual stocks and bonds. The academic theory list can go on, but these examples go to show how asset class investing, index fund investing, etc. all had academic foundations that helped fuel an investment 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 positioning and 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 investors accounted for nearly half the total assets held in ETFs.

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

The second trend that has opened the doors for ETFs has been the migration from commission-based financial advisors to fee-only financial advisors. Individuals are increasingly becoming more aware of the destructive effects of exuberant costs, tax inefficiencies and heavy trading in their portfolios. As such, they are demanding change in the way their money is managed. Many investors are hiring fee-only advisors to allocate their assets and many of these advisors are using ETFs in their portfolio strategies. Why buy 20 individual stocks and pay the commissions plus the trading costs when you can buy one ETF that already owns those securities and gives you broad exposure o the market? The more an investor saves on portfolio costs, the more is available for direct investment to fund future gains. (For more insight, read 3 Steps To A Profitable ETF Portfolio.)

How Do ETFs Compare to Mutual Funds?
ETFs are cousins of mutual funds. Let's start our comparison by naming two benefits directly associated with the diversification of your portfolio. For starters, ETFs do not have fund minimums like most mutual funds do. This is important because minimums can create a barrier to developing an efficient and well diversified portfolio. It can be very tricky to diversify a small portfolio when the fund minimums prohibit you from buying more than five mutual funds. However, when using ETFs, you have to consider trading costs if you are implementing a dollar-cost averaging strategy. Competition between brokerages tends to reduce this problem.

Another benefit to ETF investors as it relates to asset allocation within the fund portfolio is that there is no cash drag. This refers to the cash that a mutual 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 flow for a fund manager to worry about. The fund remains fully invested in the market. Mutual funds, on the other hand, have to keep a supply of cash on hand for redemptions and must invest incoming cash flows. There is very little 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, is that ETFs trade intraday, just like stocks. You can buy or sell at a given price throughout 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 is that if you see the market tanking at 11am and you decide to sell out, you can sell your ETF at the price at which it is trading at that moment in time. In contrast, if you sell a mutual fund and the market continues to go south, you will receive the price at the end of the day. The same problem occurs when the market is going up. As such, ETFs give investor much more control over how 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 offer more funds with different investment objectives. You can buy an ETF that tracks the entire index or a subset of the index. Some ETFs now track benchmarks that are adjusted and weighted by dividend yield or other fundamental factors. There are also ETFs with bear market strategies, which allow investors to profit from market downturns by shorting the indexes. This can be a great choice for investors with retirement accounts that can't short individual stocks. There are also ETFs that specialize in certain sectors like currencies, 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. The Ultra ETFs, for example, aim to increase the exposure to the indexes and provide investors with double the daily performance of the index - this can also mean double the losses.

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

ETF Type	January 2008	December 2007	January 2007
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 Equity Index	160,862	179,702	114,292
Hybrid Index	119	119	-
Bond Index	37,743	34,648	20,949
All	568,725	608,422	431,078

Source: Investment Company Institute

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

by Cathy Pareto (Contact Author | Biography)

Cathy Pareto, MBA, CFP®, AIF®, is the founder and president of Cathy Pareto & Associates, Inc., Investment Management and Financial Planning. Cathy has more than 12 years of experience in the financial services industry. After a 10-year engagement as a senior financial advisor with a large investment management firm, Cathy decided to pursue her passion for helping individuals, families, small businesses, young executives, and other professionals that have substantial investable assets, but who fall below most large investment advisory firms' account minimum requirements.