ETFs: How Did We Live Without Them?

Exchange-traded fund (ETF) products exploded onto the scene in 1993 and
continued to gain momentum. These products have a number of benefits,
including tax efficiency, cost structure and trading flexibility, to name a
few. But, how did these products come to market? What prompted their
arrival? Will they stick around? And however did we live without them? This
article will explore the origins of the ETF market and take a peek at what's to
come.

Initial Product Launch

On January 29, 1993, State Street Global Advisors, in partnership with the
American Stock Exchange, launched the first ever exchange-traded fund
(ETF) in the United States. The ETF was launched under the name SPDR 500,
ticker symbol SPY, and aimed to track the S&P 500 Index. With the success of
SPY, other companies soon followed suit, developing similar products such as
the Dow Diamonds (DIA), launched on January 20, 1998, PowerShares QQQ
(QQQQ) launched on March 10, 1999, and hundreds of others since then.

According to the Investment Company Institute, by the end of 2006, the total
number of ETFs in the market had grown to 359, with total assets at nearly
$423 billion and an expected upward growth trend. But the original SPDRs,
pronounced "spiders", have by far remained king among ETFs, with total
assets of more than $75 billion dollars as of February 29, 2008. (For related
reading, see What is a spider and why should I buy one?)

In the chart below, you can see the exponential growth of ETFs in the
marketplace. It is expected that the ETF market will expand to more than $1
trillion by the year 2010, according to projections from the Financial Research
Corp. in Boston. (For more insight, check out Advantages Of Exchange-
Traded Funds.)
 Broad-
Based Sector/Ind
Domes ustry Non-
Ye Tot tic Domestic Global/Internat Bon Registe Register
ar al Equity Equity ional Equity d red ed*
19
1 1 - - - 1 -
93
19
1 1 - - - 1 -
94
19
2 2 - - - 2 -
95
19
19 2 - 17 - 19 -
96
19
19 2 - 17 - 19 -
97
19
29 3 9 17 - 29 -
98
19
30 4 9 17 - 30 -
99
20
80 29 26 25 - 80 -
00
20
102 34 34 34 - 102 -
01
20
113 34 32 39 8 113 -
02
20
119 39 33 41 6 119 -
03
20
152 60 43 43 6 151 1
04
20
204 81 68 49 6 201 3
05
20
357 133 133 85 6 343 14
06

Figure 1: Number of ETFs, investment objective and legal

structure, 1993-2006.
*ETFs not registered under the Investment Company Act of
1940
Source: Investment Company Institute and Strategic Insight
Simfund
Academic Ties

The mutual fund and ETF marketplace have greatly benefited from the
investment principles borne in academic circles. Theories once limited to the
ivory towers of educational institutions have gained great support and
interest among commercial investment circles. For example, modern portfolio
theory suggests that building a portfolio of multiple asset types can lower
your risk while preserving or boosting returns. Asset allocation studies later
concluded that choosing the proper asset mix of stocks and bonds is more
important than picking individual stocks and bonds. The academic theory list
can go on, but these examples go to show how asset class investing, index
fund investing, etc. all had academic foundations that helped fuel an
investment industry focused on asset class. (For more on this, read Modern
Portfolio Theory: An Overview.)

Market Demand

At first, ETFs were primarily marketed to institutional investors for hedging,

transition management, tax-loss harvesting, sophisticated sector positioning
and for "equitizing" cash (the strategy of taking a given amount of cash,
turning it into an equity position and still retaining cash-like liquidity). But,
according to the American Stock Exchange, by 2008 individual investors
accounted for nearly half the total assets held in ETFs.

Market Shift

This product's shift from institutional investor to individual investors can be

attributed to two major trends in the industry. The first is the wide use of the
internet. With information, tools and education on different types of
investments readily available online, individual investors have become aware
of ETFs and their benefits, risks and costs.

The second trend that has opened the doors for ETFs has been the migration
from commission-based financial advisors to fee-only financial advisors.
Individuals are increasingly becoming more aware of the destructive effects
of exuberant costs, tax inefficiencies and heavy trading in their portfolios. As
such, they are demanding change in the way their money is managed. Many
investors are hiring fee-only advisors to allocate their assets and many of
these advisors are using ETFs in their portfolio strategies. Why buy 20
individual stocks and pay the commissions plus the trading costs when you
can buy one ETF that already owns those securities and gives you broad
exposure o the market? The more an investor saves on portfolio costs, the
more is available for direct investment to fund future gains. (For more insight,
read 3 Steps To A Profitable ETF Portfolio.)
How Do ETFs Compare to Mutual Funds?

ETFs are cousins of mutual funds. Let's start our comparison by naming two
benefits directly associated with the diversification of your portfolio. For
starters, ETFs do not have fund minimums like most mutual funds do. This is
important because minimums can create a barrier to developing an efficient
and well diversified portfolio. It can be very tricky to diversify a small portfolio
when the fund minimums prohibit you from buying more than five mutual
funds. However, when using ETFs, you have to consider trading costs if you
are implementing a dollar-cost averaging strategy. Competition between
brokerages tends to reduce this problem.

Another benefit to ETF investors as it relates to asset allocation within the

fund portfolio is that there is no cash drag. This refers to the cash that a
mutual fund carries to meet redemptions or use on investment opportunities.
This affects performance because the mutual fund is not fully invested.

Because ETFs are bought and sold over the exchanges, there's no cash flow
for a fund manager to worry about. The fund remains fully invested in the
market. Mutual funds, on the other hand, have to keep a supply of cash on
hand for redemptions and must invest incoming cash flows. There is very
little return on cash, which puts a drag on the mutual fund's performance.

Another important benefit, especially for those who like to time the market, is
that ETFs trade intraday, just like stocks. You can buy or sell at a given price
throughout the day and can set price limits. With mutual funds, on the other
hand, you buy at net asset value at the end of the day. What this means is
that if you see the market tanking at 11am and you decide to sell out, you
can sell your ETF at the price at which it is trading at that moment in time. In
contrast, if you sell a mutual fund and the market continues to go south, you
will receive the price at the end of the day. The same problem occurs when
the market is going up. As such, ETFs give investor much more control over
how and when to trade.

Other benefits of using ETFs over mutual funds that are pretty self
explanatory, including lower expense ratios, the ability to sell short, no sales
loads (usually) and sometimes tax efficiencies.

Asset Class Availability

As more investors became familiar with ETFs, ETF sponsors continued to offer
more funds with different investment objectives. You can buy an ETF that
tracks the entire index or a subset of the index. Some ETFs now track
benchmarks that are adjusted and weighted by dividend yield or other
fundamental factors. There are also ETFs with bear market strategies, which
allow investors to profit from market downturns by shorting the indexes. This
can be a great choice for investors with retirement accounts that can't short
individual stocks. There are also ETFs that specialize in certain sectors like
currencies, commodities and metals. (For further reading, check out ETFs
Provide Easy Access To Energy Commodities.)

There are also riskier ETFs for the more speculative type of investors. The
Ultra ETFs, for example, aim to increase the exposure to the indexes and
provide investors with double the daily performance of the index - this can
also mean double the losses.

Let's take a look at the ETF landscape in 2007 and 2008.

January December January

ETF Type
2008 2007 2007
Total Domestic Equity Index 370,001 393,953 295,838
• Domestic (Broad
Based) 274,190 300,930 233,935
• Domestic
(Sector/Industry) 95,811 93,023 61,903
Global/International Equity
160,862 179,702 114,292
Index
Hybrid Index 119 119 -
Bond Index 37,743 34,648 20,949
All 568,725 608,422 431,078
Source: Investment Company Institute

Conclusion
The birth of the ETF in 1993 provided investors with what we now call a blend
between a stock and a mutual fund. Any tools that help the investor improve
portfolio efficiencies and costs are a bonus. There are many great reasons to
include ETFs in your portfolio; just remember to take into consideration your
overall investment strategy, risk tolerance and portfolio costs. We can expect
that many more ETFs will enter the market, which should provide investors
and advisors with the opportunity to enter markets previously unavailable or
costly to small investors.