The Exchange-Traded Funds Manual, Second Edition

CHAPTER 2

The History and Structure of Exchange-Traded Funds—and Some of Their Competitors

The phenomenal growth of exchange-traded funds (ETFs) is a frequent topic in the financial press. These funds, with net asset inflows every year since 1995, have been warmly embraced by most advocates of low-cost index funds. The press coverage of ETFs has correctly described the major features of the most popular ETFs: (1) low expense ratios, (2) high tax efficiency, and (3) intraday trading without large premiums or discounts to the funds’ intraday net asset value. However, all the financial instruments called ETFs do not have all three of these defining characteristics and some so-called ETFs may not have any of the three. Furthermore, there is a fair degree of misunderstanding about how ETFs work, why the expense ratios tend to be low, and how most ETFs manage to avoid significant capital gains distributions. This chapter and Chapters 3 and 4 attempt to answer important ETF questions frequently asked by investors and advisors. This chapter begins with a brief discussion of how securities markets have changed in ways that made ETFs possible—and perhaps essential—in the context of investor demand for traded portfolio products. Later in the chapter we look at the historic development of ETFs and compare ETFs with some other basket products that often compete with them.

SOME MAJOR FINANCIAL MARKET DEVELOPMENTS (1975 TO 2000)

Portfolio Trading and Stock Index Futures Contracts

The basic ...