Learning the ABCs of ETFs

Few could have predicted that the rise of exchange-traded funds as mainstream investment products would happen so swiftly. As index funds that trade like stocks, they are elegantly designed for both broad and narrow asset class exposure. Furthermore, they offer all of this at a reasonable cost and with maximum tax-efficiency. Is it any surprise that ETF assets are destined to soon reach $1 trillion? Simply put, ETFs have made the world a better place to invest.

In some ways the growth pattern of ETFs has resembled that of their mutual-fund cousins.

The precursor to today’s mutual fund was the Alexander Fund. It was launched in Philadelphia in 1907 and it laid the groundwork for creating and redeeming fund shares at net asset value. Later on, in 1924, the Massachusetts Investors Trust (MIT) was introduced with the first modern open-end structure. After one year it had 200 shareholders and $392,000 in assets. Three decades later, there were 155 mutual funds with over $15 billion in assets. By the end of 2007, there were over 8,000 mutual funds with assets just over $12 trillion.

When the first U.S.-listed ETF was launched in 1993 by State Street Global Advisors, the world hardly noticed. Seven years later, the number of funds was still under 100, but ETF assets were on the verge of cracking the $50 billion mark. By comparison, mutual fund assets didn’t reach the $50 billion threshold until the end of the 1960s. What took mutual funds 45 years to accomplish, ETFs had already done in less than a decade. What led to the remarkable growth of ETFs?

“Stockbrokers needed a way to invest their clients’ money in index funds because during the late 1990s, their clients were transferring billions of dollars out of their firms to a low cost Vanguard 500 fund,” explains author Richard A. Ferri, CFA. The SPDRs S&P 500 (SPY) offered an attractive alternative to traditional index mutual funds and as more people started understanding this, assets began to grow. As a result, ETFs began to fill a void in the brokerage industry. Today, the SPDRs have amassed more than $80 billion.

Evolving ETFsThe evolution of ETFs has also expanded the number of investment opportunities.

Hedging strategies to reduce risk is a useful technique for employees who are paid with restricted securities or company stock. For example, a person working at Dell Computer could easily diversify some of their corporate stock with a corresponding technology ETF.

What about cumbersome asset classes? The introduction of currency-linked ETFs and exchange-traded notes (ETNs) has made it convenient and economical to trade and own currencies. Making a road trip to your local bank to swap foreign currency is no longer the only choice.

Likewise, the securitization of commodities through ETFs has added a new dimension of opportunity. Instead of buying, storing and insuring physical commodities, investors have a viable alternative with commodity-linked funds. From the strict viewpoint of diversification, commodities may be a good idea, but Ferri cautions, “Over the long run, an investment in physical commodities and individual commodity futures has returned about the Treasury bill rate before taxes and expenses.”