The History of Exchange-Traded Funds (ETFs)

ETFs have seen explosive growth in worldwide assets under management. But where did they come from?

Lee Davidson 14 February, 2012 | 4:58PM
Facebook Twitter LinkedIn

Abstract: Worldwide assets under management in exchange-traded products (ETPs) have seen explosive growth over the past decade. But where did they come from? The origins of ETPs can be traced back to the emergence of the mutual fund industry and subsequently traced through a series of financial innovations spurred by market crashes, liquidity crises, and depressions. ETPs were borne out of a desire for greater liquidity and flexibility. But ETPs’ structure, alone, does not account for the category’s success. Rather, the growing popularity of ETPs stems more from the behaviour of asset returns--namely, the observed difficulty associated with beating markets--and the consequential rise in use of passive investment vehicles.

Worldwide assets under management in exchange-traded products (ETPs) have seen explosive growth over the past decade, and their complexity seems to be increasing just as quickly. The emergence of ETPs and their subsequent popularisation has increased investor interest and in the process raised important questions about what ETPs are, how to analyse them, and how to use them. The commonly cited definition of an exchange-traded fund (ETF) is "a fund that trades on an exchange like a stock." However, to put ETPs into their proper historical context, we first need to revisit what mutual funds are and why they came to be. From there, we can address the genesis of ETFs and other ETPs.

Mutual funds first arose largely out of convenience. Groups of investors decided to pool their cash together into one portfolio because they did not have the time or the proficiency to invest their money in individual securities. With their collective funds pooled, investors were granted a number shares in the fund based on the amount of money they invested. The pooled fund was overseen by a competent manager who invested on their behalf. This structure offered several advantages versus investing in individual securities. First, it served to lower the cost of investing, thanks to efficiencies of scale stemming from the pooling of multiple investors’ assets. A second and directly related benefit was that investors were now able to own a greater number of distinct assets, i.e. diversify. Mathematically, the benefits of diversification can be derived with great precision and tend to result in higher returns and less risk per unit of currency invested.

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

To view this article, become a Morningstar Basic member.

Register For Free

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Lee Davidson

Lee Davidson  is an ETF analyst with Morningstar Europe.