In less than 25 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 ETFs regularly boasting 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 on ETFs, see the Investopedia tutorial: Exchange-Traded Funds: Introduction.)

Key Takeaways

  • Exchange traded funds, or ETFs, were first developed in the 1990s as a way to provide access to passive, indexed funds to individual investors.
  • Since their inception, the ETF market has grown enormously and are now used by all types of investor and trader around the world.
  • ETFs now represent everything from broad market indices to niche sectors or alternative asset classes.

Index Investing

ETFs started as an outgrowth of the index investing phenomenon. The idea of index investing didn't just come about in the last 20 years. 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. 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 indexed funds, the race was on to make this style of investment more accessible to the investing public—since mutual funds often were expensive, complicated, illiquid, and many required minimum investment amounts. ETFs, like a passively managed mutual fund, attempt to track an index, often by the use of computers, and are also intended to mimic the market.

The ETF Is Born

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 they 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 State Street Global Investors released the S&P 500 Trust ETF (called the SPDR or "spider" for short) on January 22 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.)

Barclays entered the ETF business in 1996 and Vanguard began offering ETFs in 2001. As of the end of 2018, there were more than one hundred distinct issuers of ETFs.

The Growth of an Industry

From one fund in 1993, the ETF market grew to 102 funds by 2002, and nearly 1,000 by the end of 2009.According to research firm ETFGI, there are now at least 5,000 ETFs trading globally, with more than 1,750 based in the U.S. (If you include exchange-traded notes, a much smaller category, there is an additional 1,900 globally and another 270 in the U.S.).

Along the way, an interesting "competition" of sorts had started between ETFs and traditional 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.)

Examples of Some Important ETFs

As we've mentioned, the first ETF (the S&P 500 SPDR) came to life on January 23, 1993. This fund currently has over $260 billion in assets under management and its shares trades with a price of around $280.

The second-largest ETF, the iShares Core S&P 500 ETF (NYSE:IVV) began trading in May of 2000. This fund now boasts almost $182 billion in assets under management and has a one month average trading volume of 4.2 million shares per day.

The iShares MSCI EAFE ETF (NYSE: EFA) is the largest foreign equity ETF. The EFA launched in August of 2001 and presently holds about $58 billion in assets.

The Invesco QQQ (NYSE: QQQ) mimics the Nasdaq-100 Index and presently holds assets of approximately $73 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 $20 billion in assets under management. (For related reading, see Building An All-ETF Portfolio.)

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.