In less than 20 years, exchange-traded funds (ETFs) have become one of the most popular investment vehicles for both institutional and individual investors. Often promoted as cheaper and better than mutual funds, ETFs offer low-cost diversification, trading and arbitrage options for investors.

Now with over $1 trillion assets under management, new ETF launches number from several dozen to hundreds in any particular year. ETFs are so popular that many brokerages offer their customers free trading in a limited number of ETFs. (For related reading, see Introduction To Exchange-Traded Funds.)

(For more, see the Investopedia tutorial: Exchange-Traded Funds: Introduction.)

Beginning at the Beginning

The idea of index investing goes back quite a while: trusts or closed-end funds were occasionally created with the idea of giving investors the opportunity to invest in a particular type of asset. However, none of these really resembled what we now call an ETF.

According to Gary Gastineau, author of "The Exchange-Traded Funds Manual," the first real attempt at something like an ETF was the launch of Index Participation Shares for the S&P 500 in 1989. Unfortunately, while there was quite a bit of investor interest, a federal court in Chicago ruled that the fund worked like futures contracts, even though they were marginalized and collateralized like a stock; consequently, if there were to be traded they had to be traded on a futures exchange, and the advent of true ETFs had to wait a bit.

The next attempt at the creation of the modern Exchange Traded Fund was launched by the Toronto Stock Exchange in 1990 and called Toronto 35 Index Participation Units (TIPs 35). These were a warehouse, reciept-based instrument that tracked the TSE-35 Index.

Three years later, the American Stock Exchange released the S&P 500 Depository Receipt (called the SPDR or "spider" for short) in January of 1993. It was very popular, and it is still one of the most actively-traded ETFs today. Although the first American ETF launched in 1993, it took 15 more years to see the first actively-managed ETF to reach the market. (For related reading, see An Introduction To Corporate Bond ETFs.)

As mentioned, the idea of index investing didn't just come about in the last 20 years. In response to academic research suggesting the advantages of passive investing, Wells Fargo and American National Bank both launched index mutual funds in 1973 for institutional customers. Mutual fund legend John Bogle would follow a couple of years later, launching the first public index mutual fund on Dec. 31, 1975. Called the First Index Investment Trust, this fund tracked the S&P 500 and started with just $11 million in assets. Referred to derisively by some as "Bogle's folly," the AUM of this fund crossed $100 billion in 1999.

Once it was clear that the investing public had an appetite for such funds, the race was on. Barclays entered the business in 1996, State Street in 1998 and Vanguard began offering ETFs in 2001. As of the end of 2011, there were over 15 issuers of ETFs.

The Growth of an Industry

From one fund in 1993, the ETF market grew to 102 funds in 2002 and nearly 1,000 by the end of 2009; ETFdb lists over 1,400 ETFs in its database as of Dec. 20, 2011. By the end of 2011 it looked as though total assets under management at ETFs would approach or exceed $1.1 trillion, a sizable amount of money, but still very small compared to the nearly $12 trillion that is held by mutual funds.

Along the way, an interesting "competition" of sorts had started between ETFs and mutual funds. 2003 marked the first year where ETF net inflows exceeded those of mutual funds. Since then, mutual fund inflows have typically exceeded ETF inflows during years where market returns are positive, but ETF net inflows tend to be superior in years where the major markets are weak. (For related reading, see 5 Reasons Why ETFs Work For Young Investors.)

Important Milestones

As mentioned, the first ETF (the S&P SPDR) began trading on Jan. 1, 1993. This fund currently has over $86 billion in assets under management and trades a quarter-billion shares on an average day. To put that in perspective, consider that the New York Stock Exchange first saw average daily volume surpass 200 million shares per day, in 1992!

The second-largest ETF today, the SPDR Gold Shares (NYSE:GLD) began trading in November of 2004. This fund now boasts almost $73 billion in assets under management and is believed to be the sixth-largest owner of gold in the world; just ahead of China and holding about 14% as much as the U.S. government.

Although Vanguard was a little late to the ETF scene, the Vanguard MSCI Emerging Markets ETF (NYSE:VWO) is the largest foreign equity ETF. The VWO launched in March of 2005 and presently holds about $56 billion in assets.

The PowerShares QQQ (NYSE:QQQ) mimics the Nasdaq-100 Index and presently holds assets of approximately $24 billion. This fund launched in March of 1999.

Last and not least, the Barclays TIPS (NYSE:TIP) fund began trading in December of 2003 and has grown to over $22 billion in assets under management. (For related reading, see Building An All-ETF Portfolio.)

The Future

While ETFs are clearly popular and still experiencing considerable net inflows, ETFs are unlikely to surpass mutual funds anytime soon. Mutual funds have several important advantages over ETFs that should help maintain that lead.

Mutual funds are key offerings in retirement and pension funds and some fund plans do not even allow investors to buy or hold individual securities like ETFs. Mutual funds also offer active management and that is a key advantage to many investors; passively managed funds can only match a given index and reduce investing to strategic allocation decisions. Actively-managed funds, though, can offer market-beating performances that accumulate significantly over time. While actively-managed ETFs could chip away at this advantage, it will take considerable time.

The Bottom Line

While ETFs do offer very convenient and affordable exposure to a huge range of markets and investment categories, they are also increasingly blamed as sources of additional volatility in the markets. This criticism is unlikely to slow their growth considerably, though, and it seems probable that the importance and influence of these instruments is only going to grow in the coming years.

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