The Fund Industry: How Your Money is Managed, 2nd Edition

CHAPTER 15

Exchange-Traded Funds

Exchange-traded funds—commonly referred to as ETFs—have been a disruptive technology in the fund industry. They have transformed the way that funds are bought and sold, increased interest in low-cost index-based investing and given investors new options for their portfolios. In the meantime, their growth has snowballed; at the end of 2013, ETF assets accounted for 10 percent of the industry total.¹

In this chapter, we review the ETF phenomenon, from its origins to its future. We will look at:

• The history and growth of ETFs.
• The advantages and disadvantages of ETFs compared to traditional mutual funds.
• The legal structure of ETFs.
• How ETFs operate from day to day.
• Investments in ETFs.
• The outlook for ETFs.

A BRIEF HISTORY

The recent growth of ETFs has been eye-catching, especially when compared with the overall growth in the fund industry. That hasn't always been the case. The ETF industry grew slowly in the dozen years after the launch of the first ETF in 1992. (See “Of SuperTrusts, SPDRs, and WEBS” for more about the earliest ETFs.) At the end of 2004, there were only 152 ETFs from a handful of sponsors with just $228 billion in assets.

In the mid-2000s, however, ETFs hit a tipping point, and growth took off. By the end of 2013, the industry had grown to more than $1.7 trillion in assets in close to 1,300 funds. Over the past 10 years, ETFs have grown at a compound annual growth rate of 27 percent. Growth for traditional mutual funds was only ...