The rise of ETFs and what they do

London Stock Exchange in partnership with What Investment and industry professionals have created a series of articles offering investors insight into ETFs covering a range of assets classes and strategies.

The first of these articles is:

The rise of ETFs and what they do

by Lee Kranefuss, Executive Chairman at Source

Anyone can be excused for thinking Exchange Traded Funds (ETFs) are new, because although they’ve been around for more than 25 years, it’s only been in the last few that they’ve started gaining serious momentum in the UK. It may surprise you to learn that they came into existence in the same year as the internet and, at a basic level, ETFs do for investors what the internet has done for consumers: increase efficiency, reduce costs and bring innovative solutions to the masses.

This article will look into the origins of ETFs – when and why they came into being – and how they can be used by investors today.

When they were created

The first ETF was launched in 1990, not in the UK or even in the US, but in Canada. It was the Toronto 35 Index Participation Units (TIPs). Three years later saw the launch of the Standard & Poor’s 500 Depository Receipts (SPDR) on the American Stock Exchange, later listed on other exchanges and currently the largest ETF in the world.

European investors would have to wait until 2000 for the first ETF to be launched in Germany, tracking the EURO STOXX 50. Shortly thereafter came the first ETF launched in the UK, which tracked the FTSE 100.

Why they were needed

You may notice that each of those early ETFs provided exposure to the market’s primary index. That’s because they were responding to where the demand was. Index investing has been an important tool for pension funds and other large institutions since the 1970s, when mutual fund houses developed index trackers to provide inexpensive core market exposure. They became very popular but had their drawbacks. For starters, if an investor wanted to buy units, they would deposit cash with the mutual fund company, which would then issue units at whatever the price was at the next valuation point, typically the end of the day. This wasn’t ideal for investors who preferred to invest at a time and at a price of their choosing – similar to how they traded stocks.

ETFs had the solution and it involved the stock market. An investor would go directly to their broker and buy shares in the ETF whenever they wanted to during the normal trading day. Plus, they’d know the price before they traded because – just like with common stocks – there would be market-makers quoting the price they’d be willing to buy and sell at that given time. In other words, ETFs provided the same index exposures but with more trading flexibility.

How they were – and still are – used

ETFs can play a variety of roles for investors wanting to diversify their portfolios. Most investors are still likely to have their first exposure to ETFs through a low cost index ETF, often as a replacement for an underperforming, more expensive actively managed fund, or an existing index mutual fund.

These longer-term, core exposures continue to play an important role in portfolios, especially for US exposure, which comprises around 40% of the global equity market, but where few actively managed funds have been able to beat the S&P with any consistency.
So, rather than trying to beat the index (and the odds), an index ETF simply aims to match it. And instead of charging a management fee of up to 2 per cent per annum, it could be as low as 0.05 per cent. Index ETFs that offer exposure to traditional market-cap- weighted indices are often referred to as “beta” exposures.

There’s a second broad category of ETF that’s been growing strongly over the past few years. “Smart beta” ETFs offer exposure to indices that select and weight the components using characteristics other than just market capitalisation. Many use one or more equity risk factors, for instance selecting stocks that meet certain valuation, momentum or dividend criteria. These factors are based on academic research and have been used by investors for decades, even by active managers. The difference with smart beta ETFs is that they use algorithms instead of human discretion, and in theory should yield more consistent results and be cheaper than the average actively managed fund.

What does the future hold?

We expect further growth in the use of ETFs, with a broader range of investors likely to be attracted by their lower costs, trading flexibility and increased transparency. The wide choice of beta and smart beta ETFs enable investors to gain inexpensive core exposure along with the tools for tailoring portfolios to reflect their personal objectives, economic conditions and market expectations.

Indeed, ETFs are as valuable today as in their initial days, not just for institutions but for any investor wanting an alternative to more expensive – and often underperforming – actively managed funds.

We are even beginning to see portfolios created entirely with ETFs, so you could argue they’re now even more valuable. Reminds us that some people thought the internet wouldn’t catch on either.

This article is provided by Source as part of the London Stock Exchange educational series in partnership with What Investment.