A Brief History of Exchange-Traded Funds

When introduced in 1993, exchange-traded funds (ETFs) had a quiet debut, barely registering among average investors. For the next decade, even as major investors saw their potential, overall trading in them was barely a blip, with ETFs breaking 1% of fund trading only in 2000. At the time, retail investors largely stuck to regular deposits in their 401(k) mutual funds. Today, ETFs are among the most popular investments for institutional and individual investors, usually accounting for between 26% to 30% of the daily trading volume in the U.S. in recent years.

But how did ETFs gain such a toehold in the financial world? Below, we explore the origins of ETFs, highlight the factors that contributed to their widespread adoption, and examine how they have changed with the market.

What Makes ETFs So Popular?

Often promoted as cheaper and better than mutual funds, ETFs offer low-cost diversification, easy trading, and passive investing for most trading in them. The most significant advantages of ETFs are their lower fees and trading flexibility. Unlike mutual funds, which are priced once a day after the market closes, ETFs can be bought and sold throughout the trading day like individual stocks. This allows you to react quickly to market events, employ sophisticated trading techniques, or wait out short-term storms looking to profit from your passive index ETF holdings.

The first ETFs drew their portfolios from shares in the S&P 500 and other indexes. After a major shift in the early to mid-2000s, funds could hold bonds (2002), commodities (2004), currencies (2005), inverse and inverse products (2006), real estate investments and trusts (2000), and volatility (2009), among others. However, none of these caused the storms that occurred before cryptocurrency futures (2021) and spot crypto ETFs (2024) arrived.

The brokerage industry has trumpeted the advantages of ETFs. Many now offer commission-free trading on select ETFs to attract and retain customers. As the debates over crypto funds have shown, they are also seen as a way to bring mainstream investment capital toward areas of finance previously unavailable on the U.S. stock exchanges, whether commodities, volatility, or cryptocurrencies.

Index Investing

Before ETFs became a cornerstone of modern investing, several trends had to come together, especially the rise of mutual funds and index investing. The latter gained traction in the 1970s. During that period, academic studies and influential works like Burton Malkiel's 1973 "A Random Walk Down Wall Street" argued that most investors would be better off investing in a low-cost, diversified portfolio that tracked a broad market index rather than trying to beat the market.

Wells Fargo and American National Bank launched index mutual funds in 1973 for institutional customers. Three years later, Vanguard came out with its First Index Investment Trust, a fund that tracked the S&P 500 and was open to the public. It wasn't just unassuming in name: it started with only $11 million in assets. The fund was met with skepticism and derided as "Bogle's folly," after John Bogle, Vanguard's founder. Now known as the Vanguard 500 Index Fund, it remains one of history's largest and most successful mutual funds.

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. Mutual funds often were expensive, complicated, and illiquid, and many required minimum investment amounts. Despite these drawbacks, they reached $1.5 trillion in assets in 1993, a pivotal year in investment funds history.

The ETF Is Born

Parallel to the development of index funds, advances were made in trading technology and financial engineering. In the 1980s, stock index futures and options were introduced, allowing investors to hedge or speculate based on the anticipated future values of stock indexes.

In 1990, investors on the Toronto Stock Exchange could begin buying shares in the Toronto 35 Index Participation Units (TIPs 35). This warehouse, receipt-based instrument tracked the TSE-35 Index, essentially a Canadian ETF. Three years later, State Street Global Investors launched the S&P 500 Trust ETF (the SPDR or "spider" for short; SPY), the first American ETF. It remains the largest fund in the world, with over $500 billion in assets. Although the first American ETF launched in 1993, it took 15 more years for the first actively managed ETF to reach the market.

From one fund in 1993, the market grew to 102 by 2002 and almost 1,000 by the end of 2009. Barclays entered the ETF business in 1996, and Vanguard began offering ETFs in 2001. As of 2024, there were over 12,000 ETFs available worldwide, with about 600 different fund management companies providing them.

ETFs on the Rise

If the launch of mutual funds available to the public was initially known as a folly, at least it received public notice, which can't be said of the launch of ETFs in 1993. Trading remained relatively low throughout the 1990s despite the massive growth of the dot-com era. By 2000, ETFs had assets that were barely 1% of those of mutual funds.

But this would begin to change, not least because many in the investing community saw ETFs—traded on U.S. exchanges like any stock—as a way to provide access through regulator brokerage accounts to off-exchange assets. Previously, you would have to find a specialized broker to help you, say, trade in the commodities markets. You could now trade in gold indirectly by purchasing shares that represented fractional ownership of an ETF that held it in its portfolio.

In the 2000s, there was a vast expansion of ETFs into new asset classes and strategies, transforming them from a niche product into a fundamental tool for both retail and institutional investors. The decade began with ETFs primarily focused on broad market indexes. In 2001, the iShares MSCI EAFE ETF (EFA) began trading, providing exposure to international stocks (excluding the U.S. and the Republic of Korea) and making it far easier to diversify across the globe with a single purchase of shares.

Around the same time, bond ETFs gained popularity—it's still the second-most traded type of ETFs after equities—with the introduction of the iShares Barclays Aggregate Bond ETF in 2002.

In 2004, the SPDR Gold Shares (GLD) ETF gave exchange-traded access to commodities for the first time. A year later, currencies were included when the Euro Currency Trust (FXE) debuted, offering investors the ability to hedge or speculate on changes in foreign exchange (forex) rates.

ETFs were also becoming funds with strategies far more advanced than passive investing. Investors had new sophisticated tools to magnify their returns or profit from market declines. For example, in 2006, ProShares launched its first leveraged and inverse ETFs, offering two times or negative-two times the daily returns of market indexes. These tools were particularly appealing during the volatile market conditions leading up to and following the 2008 financial crisis.

The rapid growth of the ETF industry also brought regulatory attention. In 2008, the U.S. Securities and Exchange Commission (SEC) began a rigorous review of them, especially those using derivatives and complex strategies. Despite SEC concerns at the time, the flexibility and range of ETFs continued to attract a broad base of investors. By the end of the decade, the number of ETFs had grown exponentially, and the assets under management (AUM) for U.S. ETFs surged toward the $1 trillion mark.

ETFs Since the 2007-2008 Financial Crisis

Once the worst of the 2007-2008 financial crisis period passed, fund managers continued to introduce more diversification from more specialized and niche products. In the next decade, major trends included the rise of thematic ETFs, which focus on specific investment topics that cut across industries, such as robotics, artificial intelligence, and clean energy. These funds allowed investors to target more speculative or leading-edge sectors without the need for in-depth industry knowledge to pick out specific stocks.

Environmental, social, and governance ETFs, which began trading the decade before, gained prominence, reflecting a growing interest in socially responsible investing. These screen for companies based on specific ethical criteria, providing investors with options that align with their values while still seeking competitive returns.

Fixed-income ETFs also evolved, with offerings that more precisely targeted specific maturity profiles for bonds, credit risks, and yields. Multi-asset ETFs, which provide exposure to a mix of stocks, bonds, and other assets within a single ETF, became popular for offering balanced and diversified portfolios tailored to specific risk tolerances and investment goals.

2019 – 2022

In 2019, the SEC adopted the ETF Rule, which streamlined the process of bringing new ETFs to the market, especially those using different strategies to trade. That openness was put to the test immediately as the SEC had many applications for ETFs related to various cryptocurrencies. In 2021, the SEC approved bitcoin futures ETFs (ether futures ETFs followed two years later), which allowed investors exposure to the currency without buying them directly. There was also the added layer that these were regulated futures, not the actual tokens.

The regulator continued to bat down proposals for ETFs that held crypto directly. The SEC was hesitant to approve spot bitcoin ETFs because of concerns over market manipulation, liquidity, and security for the crypto these funds held. Meanwhile, the SEC increased its oversight following a series of bankruptcies involving major cryptocurrency platforms such as FTX, BlockFi, and Voyager Digital. In response to these failures, the SEC doubled the size of its crypto and digital-asset-related staff. Meanwhile, SEC Chair Gary Gensler was a well-known crypto skeptic, saying its markets were "rife with abuses and fraud."

2023 – 2024

However, following a federal appeals court ruling in 2023, the SEC relented, and 11 spot bitcoin ETFs began trading in January 2024. These allow investors to gain direct exposure to the actual cryptocurrency, unlike futures-based ETFs, which only track price movements through those contracts. On May 23, 2024, The SEC approved applications from the NYSE, Nasdaq, and CBOE to list ETFs tied to the price of ether.

Examples of Important ETFs

The first ETF, the S&P 500 SPDR (SPY), had about $535 billion in AUM as of June 7, 2024, and its shares traded at a price of around $534.

The second-largest ETF, the iShares Core S&P 500 ETF (IVV), began trading in May 2000. This fund had over $469 billion in AUM and a one-month average trading volume of 4.2 million shares.

The iShares MSCI EAFE ETF (EFA) is the largest foreign equity ETF. It launched in August 2001 and held about $54.9 billion in assets as of June 7, 2024.

The Invesco QQQ (QQQ) mimics the Nasdaq-100 Index and held assets of over $269 billion in June 2024. This fund launched in March of 1999.

Another prominent fund is iShares TIPS Bond ETF (TIP), which began trading in December 2003 and had over $18 billion in AUM in June 2024.

The Bottom Line

The first ETF was launched in Canada in 1990, which paved the way for the introduction of the first U.S. ETF, the SPDR S&P 500 ETF Trust, in 1993. Designed to offer investors the diversification of a mutual fund with the flexibility of stock trading, ETFs took time before they started to grow rapidly in popularity.

Over the last three decades, the ETF market has expanded to include various asset classes, including bonds, commodities, and international markets, along with more complex tools like leveraged and inverse ETFs. The 2000s and 2010s had further diversification with the introduction of thematic and ESG-focused ETFs, reflecting broader economic and social trends. By the 2020s, the start of trading for cryptocurrency futures and then spot crypto ETFs had critics. Still, they showcased the adaptability of ETFs to evolving investor demand as they've come to occupy a significant part of the modern investment landscape.

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