A brief history of ETFs

Brief history of ETFs key takeaways:

• The first ETF ever listed in the U.S. dates back from 1993 and is now a landmark ETF (SPY)
• ETF growth started on the back of passive investing and the first generation of ETFs were tracking market indices
• ETFs have encountered success in the 2000’s and have since developed across all assets classes, some focusing on specific investment themes and some on active strategies

Exchange-Traded Funds (ETFs) have come a long way since the first U.S. listing in 1993. They are now listed on exchanges all over the world and are found in the portfolios of investors from the largest institutions to the smaller private investor. Investors have adopted them as a simple investment solution bringing an easy, low-cost and liquid access to a broad range of assets classes, geographical and sector exposures as well as more active investment strategies.

ETFs’ popularity has grown over the past two decades. They have become the fastest growing product in the investment industry, both in term of assets under management and in terms of product innovation. How did this happen? We take you back in time to explore the history of ETFs.

It all started with efficient investing and index funds

ETFs are pooled investment vehicles, but they were not the first to use this structure. Collective funds were invented long before the first ETF ever hit the market. The first modern-day mutual fund, the Massachusetts Investors Trust, was created in the US in 1924. Its innovative open-ended structure supported the continuous issue and redemption of shares, meaning that for the first time, investors could easily pool assets together into an investment vehicle managed by professionals.

ETFs were made famous as index trackers, however they were not the first to take this approach. Passive investing, also known as index investing is a simple strategy that looks to replicate the return of an index. This revolution began in 1975 with Vanguard launching the first index mutual fund, tracking the S&P 500 index. Building on Eugene Fama’s work on the efficient market hypothesis, the fund looked to simply buy the market instead of trying to outperform it.

Yet despite this innovation, investors were still lacking the major benefit of ETFs – the possibility to trade fund shares on an exchange. This next step came about in the 1980’s with the development of electronic trading. Traders started to look for ways to purchase all the components of an index in a single trade. A solution came in 1993 with the launch of the first ETF in the United States, the SPDR SPY which, to this day is possibly the most well-known ETF in the world.

ETF’s booming innovation and ever-growing range of products

The SPY was an immediate success and grew to become the largest ETF in the world with assets under management reaching $364bn as of April 2021. More ETF launches quickly followed, tracking other U.S. large cap indices such as the Dow Jones (in 1998) and the Nasdaq 100 (in 1999). Originally focused on equity indices, the ETF industry began to cover other asset classes such as fixed income, REITs and commodities, alongside so-called ‘Smart Beta’ and factor indexes that helped ETFs become a favourite vehicle for index-based investing.

2000 was a significant year for ETFs. The first factor-based ETF came into existence in the US in year 2000 to answer the appetite for smart rule-based strategies. In the same year, ETFs reached Europe.

Fixed income had historically been an asset class that was difficult for many investors to access – bonds are traded in large sizes in Over the Counter (OTC) markets and are often thinly traded making price discovery challenging. For many investors, the complexity of the fixed income markets made it almost impossible to take advantage of the full range of opportunities in this asset class. This changed in 2002 when providers began to launch ETFs on fixed-income indices.

For the first time, the average investor could trade fixed income as easily as a share and the ETF wrapper brought previously unheard of access and liquidity to a traditionally illiquid asset class. Now bond ETFs are ubiquitous and provide a huge range of choices for investors who want to access government, corporate or agency bonds from different markets and issuers.

In 2004 SPDR were the first to set up a commodity ETF, the SPDR Gold Trust (GLD). A year later the first sustainable ETF was made available for investors.

With the approval of the SEC, 2006 saw the advent of short and leveraged ETFs in the U.S. These new ETFs provided either an inverse performance to the index they tracked, or provided multiples of the performance of the index.

In 2010, ETFs made their revolution by moving away from indices with the introduction of the first active ETF fully transparent on its holdings the Bear Stearns Current Yield Fund. The same year ETFs surpassed $1 trillion of assets globally. More recently, in 2019, the S.E.C has granted approval for listing semi-transparent ETFs.

In February 2021, as financial markets rebound from the coronavirus crisis, ETFs have reached the $8 trillion milestone with almost 7,000 funds available to investors worldwide.

This milestone, although impressive, is still just the start for ETFs and the future seems set for even more innovation, a broader range of exposures and a whole new ecosystem of investors joining the ETF party.

ETF growth fuelled by new investment strategies and behaviours

Aside from an increasing product range from ETF providers, new trends in portfolio management are also helping foster a greater adoption of ETFs.

Rule-based strategies are a great example. They rely on quantitative models to determine portfolio allocation, instead of relying on the discretionary judgement of investors. ETFs’ unique benefits of diversification, liquidity and tradability make them great building blocks for these systematic portfolios.

Moreover, modern investment techniques such as risk-based investing and advanced asset allocation models have made ETFs an essential tool for most investors, from retail investors overseeing their pensions to professional investors building solutions for large asset owners or private banking clients.

More recently, the rise of digital investment solutions, known as ‘robo-advisors’, pushed ETF assets higher as their tradability makes them a perfect match for automated investment processes. Even though market volatility has been exceptionally high in the wake of the coronavirus crisis, ETFs have remained a preferred way for investors to adjust their exposure to stocks and bonds.

Conclusion

Since their introduction in the 90’s, ETFs have completely changed the investment industry landscape. Over the past decades they have been the fastest growing product both in assets but also in terms of product range. If ETFs started out by tracking large cap equities indices, they have now conquered all asset classes, investment themes and strategies. And the recent development of active semi-transparent ETFs could lead them to break further away from indices.

Changes in portfolio management techniques also helped the adoption of ETFs, with the rise of systematic as well as risk-based solutions. Despite the recent market turmoil, the assets invested through ETFs have shown no sign of levelling off, displaying their incredible strength and the whole ecosystem’s faith in the wrapper.

What’s next for ETFs? Issuers’ race for innovation, made possible by the new regulations, leave room for further development of ETFs, which are expected to reach over $12 trillion in assets under management by the end of 2023 [1].

[1] Blackrock - Four big trends to drive ETF growth - May 2018