ETFs are widely viewed as an effective way to build a diversified portfolio, as a cost effective way to access various market segments, and as pooled investment vehicles that are generally cheaper, more convenient to trade, more transparent, and often more tax efficient than their counterparts – namely, mutual funds. But where did they come from? And where are they headed next? This article will answer those questions.
The creation of ETFs is often traced to a 1988 invitation by the SEC to create a market-basket vehicle based on the S&P 500. This invitation came after the crash of October 1987 when retail investors who were unable to sell their holdings until after the end of the trading day absorbed large losses. The SEC’s invitation was accepted and five years later (after a few false starts), in January of 1993, SPY started trading on the American Stock Exchange. SPY is widely considered to be the first ETF1. Its legal structure is a unit investment trust, and it tracks the Standard & Poor’s 500 Index. SPY’s structure requires it to hold all securities weighted exactly as in the index, and it cannot reinvest dividends received from the underlying stocks it holds.
Improving upon the unit investment trust, the first ETFs structured as ‘Open-end funds’ under the provisions of the Investment Company Act of 1940 were launched in 19962. Often referred to as “40 Act ETFs”, these ETFs are able to re-invest cash dividends, sample an index, use derivatives, and engage in securities lending. Today over 95% of ETFs are structured as ’40 Act funds. This structure opened the door for bond ETFs (the first of which was launched in 2002)2.
ETFs holding commodities were launched in 2004. While the first commodity ETFs were structured as grantor trusts (which are limited to holding precious metals and currencies), ETFs holding commodity futures and structured in the form of commodity pools launched soon after in 20062. Investors using ETFs structured as commodity pools should generally expect K-1s at tax time.
In 2008, the SEC started approving actively managed ETFs1. These ETFs do not track the performance of a specific index, but rather select and weigh securities at the discretion of their managers (similar to actively managed mutual funds). However like other ETFs, active ETFs are still required to disclose their holdings daily. This has prevented many active managers from embracing the ETF structure due to their concerns that their best investment ideas could be copied by other market participants. New structures may be coming to market in the future that could solve the disclosure challenge.
In November 2009, Charles Schwab greatly improved the ETF investor experience by introducing Schwab ETFs and allowing investors to trade them commission free on Schwab.com. Other brokerages also saw the benefit of granting access to ETFs commission-free. Schwab has consistently been a leader in commission-free trading. In 2013, the commission-free line-up at Schwab was significantly expanded with the launch of ETF OneSource, which now boasts over 250 ETFs representing a wide range of asset classes (all of which trade commission free on Schwab.com)3.
The recent growth of the ETF industry has been tremendous. It took almost eighteen years for ETF assets to reach one trillion dollars in December of 2010. The assets reached a milestone of two trillion in 2014 and crossed three trillion in 20172. This growth does not seem to be slowing down. Flows into ETFs continue to break records, and the industry is shining with its innovation and development. After 25 years of history, many still believe ETFs are in their infancy. All signs point to the likelihood that the industry will continue to evolve in the years to come.
Source: Morningstar Direct, 2018
Now that you know where ETFs came from, move on to the next article in this series to find out how shares of ETFs are created and traded.