The incredible rise of exchange-traded funds

The incredible rise of exchange-traded funds
Image: Antonio Sortino for Quartz
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About 30 years ago, a revolutionary investment product crept into the market: the exchange-traded fund. As it was introduced, a handful of experts, from Vanguard founder Jack Bogle to the CFOs of some of the world’s largest foundations, shied away. “We’re for long-term investors, not for short-term traders,” Bogle told Nathan Most, the inventor of the first US-based ETF. Bogle never warmed to ETFs. But over the ensuing decades, just about everybody else did, including Vanguard, after Bogle retired.

ETFs, essentially funds that trade like stocks, made it much easier and cheaper to own and trade big groups of stocks at once, on demand. Investors could diversify their exposure by buying entire baskets of securities—like one holding the stocks of every company in the S&P 500—without buying and selling the underlying individual securities. And they could avoid some tax consequences of those 500 individual transactions. To a retail investor, they look a lot like index mutual funds and have fueled a shift toward passive investing. But as they have evolved, some experts have begun to worry about how they’re affecting the world’s capital markets.

This year, the global market in exchange-traded funds hit $5.46 trillion, with more than $4 trillion of that in the US markets. The most widely traded stock in the world during some months is an ETF: the fund that tracks the S&P 500 called SPY. It’s run by State Street (the investment company that Most took his idea to). Some other popular ETFs now trade more often than most of the underlying stocks in their indexes, like Invesco’s QQQ, which has become a quick way to invest in tech stocks because it holds the top 100 stocks trading on the NASDAQ.

ETFs have closed in on 10% of the $51.4 trillion in global assets funds hold, based on data from the International Investment Funds Association (the public markets are an estimated $70 trillion). Meanwhile, ETFs account for about 30% of the trading volume in the US markets.

As ETFs have exploded in popularity something has changed in the way the world’s capital markets function. Public markets have long provided an efficient way for companies to raise capital to expand or fund research and innovation. Today, they increasingly exist to service finance firms and institutional investors, who profit by intraday market manipulations. 

For companies seeking to raise capital it’s been a double whammy: Increasingly passive retail investors have less interest in small companies and new ideas, and financial firms have less incentive to figure out how to bring them to market. The number of US public companies has dropped by more than half since its peak in the late 1990s.

Sophisticated market watchers are also worried about ETFs’ fast growth and the fact that they’ve never been tested in a big downturn when they accounted for as much of the market as they do now. Their concern stems in part from the two-tier structure that has grown up around ETFs.

Financial products are typically sold, not bought. ETFs are no exception. The majority of their growth came about after the financial crisis, when investment companies, both big fund companies and big brokerage firms, were looking for a new product to tempt investors back into the market. Most investors use them as low-cost, tax-efficient tools to own big indexes for the long term, like the S&P 500.

But the structure of ETFs means that as retail investors have been pouring money into ETFs, financial firms have developed new ways to turn profits and reduce risk for themselves and their larger clients, like other financial firms, family offices and wealth funds. (They’ve been under pressure to do so, as regulators tamped down on high profits financial firms used to make on simple trading.)

More than 90% of ETF trading happens in this professional market, according to a Vanguard analysis of Morningstar data. (More on that part of the market, below). Professional investors use ETFs for complex trading strategies, to quickly make big bets in the market, offset risk, or take advantage of pricing moves in the market.

There is a worry about ETFs and the way they’ve taken off that harkens back to the reason Bogle rejected them in the first place: Trading isn’t the same as investing. And no one knows what will happen in a downturn if all the complicated trades on all the ETFs being performed hourly get out of whack. 

Some people believe that the liquidity will help the markets, like Rich Powers, head of ETF product management at Vanguard. “There has been no shortage of events where they’ve had a chance to be tested,” he says. “In the depths of the financial crisis when investors were unable to sell their corporate bonds, investment grade ETFs were able to be sold even when there wasn’t a buyer.”

Others worry about what happens if everyone heads for the exits at once, as could happen in the case of a big macroeconomic shock followed by some trading snafus in small ETFs. Panic can spread, say the worriers. “I call this the turd in the pool phenomenon,” says Tim McCarthy, a former president of San Francisco-based Charles Schwab and Japan’s Nikko Asset Management. “If a baby diaper loses a turd in the deep end, everyone wants to get out.”

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Remaking markets in their image

Aside from the small or large risk of the mother of all market crashes, ETFs are helping to drive a transformation in today’s capital markets. Where markets formerly served the needs of companies that wanted to raise money, markets are drifting now toward operating to serve the interests of financial firms, the super rich, and big institutional investors, like pension funds or sovereign wealth funds. 

In the 20th century, old-school investors like Jack Bogle and Warren Buffett built an institution and a fortune, respectively, on the idea that over time investors make money by providing capital to well-run companies with good ideas. Bogle was always clear on the idea that even if you invested passively, you were investing in the potential of the underlying companies to grow.

Value investing at this point seems almost quaint.

In the new public markets, investors look for “exposures” to different sectors, which ETFs provide. “This is one of the great benefits of ETFs,” says Emil Tarazi, co-founder at research firm ETFLogic. “Ten-15 years ago a professional investor couldn’t easily trade commodities, EM, currencies, floating rate bonds … now they have them all at a click of a button and can rotate their exposures continuously.”

Capital flows to companies like Microsoft, Amazon or JPMorgan that already belong to indexes, especially the big, popular indexes. Innovative startups and smaller companies, meanwhile, are being funded for a longer time in the quieter private markets, away from the whipsaws of the trillion-dollar funds and computer algorithms. It’s a shift that has led to private equity’s growth: the private market grew sevenfold since 2002, to $5.8 trillion in 2018, twice as fast as global public equities, according to McKinsey.

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What ETFs mean for investors

The changes have upsides and downsides for individual investors, who are paying less for investments as trading and management in the public markets are increasingly commoditized. ETFs are inexpensive—the average expense ratio for all of them was .2%, according to data provider ETFDB—and ETFs kicked off what’s been called the race to zero. “It turned out there was this dynamic, where the lowest costs and most liquid products were rewarded with the biggest flows,” says Daniil Shapiro, associate director of product development at research firm Cerulli. In other words, investors went where the fees were dropping.

Vanguard had always been inexpensive, but with ultra-cheap ETFs in the mix, traditional mutual funds started dropping their prices, too. Fidelity became the first to offer a zero-fee mutual fund in late 2018. Broker-dealers like Schwab, meanwhile, started offering commission-free trading. 

But the reshaped markets mean small investors increasingly don’t have access to the big returns generated by innovation—because small and new companies are avoiding the public markets. Over the 25 years ended in March, private equity funds returned more than 13% a year, compared with about 10% for the S&P 500, according to Cambridge Associates.

One thing ETFs definitely haven’t done: “democratize” investing. Many companies and people that launch or use ETFs like to claim they’ve made investing more accessible, because ETFs have lowered the prices for investing. But stock ownership has become more concentrated among wealthy households. Today, households in the top tenth percentile of wealth own more than 90% of the U.S. stock market, compared with 85% in 1989, according to a January 2019 Goldman Sachs report. Lower fees don’t help households that don’t have money or means to invest in the first place.

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The ETF origin story

ETFs were born out of a need in the market after the crash of 1987. After Black Monday, when the Dow Jones Industrial Average fell more than 20% in a single day, people started looking for a mechanism that would allow investors to quickly buy in the midst of a big downturn.

In 1990, the Toronto Stock Exchange launched the Toronto 35 Index Participation fund. While the Canadian ETF was growing slowly, a former commodities trader named Nathan Most was thinking about the same problem. He told Institutional Investor in an interview shortly before he died in 2004 that he came up with the idea for ETFs based on his knowledge of how warehouses issue bulk receipts to commodity owners. 

It took three years, according to the interview, for Most to convince Amex to invest in the creation of an ETF and another three for the first ETF to make it through the arduous SEC approval process. For their first two decades, ETFs were mostly used for that original purpose, by professional investors to manage risk.

In 2009 following the financial crisis, there were 797 ETFs in the US, with $777 million in assets, according to the Investment Company Institute. Fund companies, meanwhile, had a problem: Their mutual funds weren’t selling so well anymore.

 “With a lot of money sitting on the sidelines after the financial crisis, it was hard to tell the story of returns and due diligence,” says David Lyon, a former investment advisor based in Chicago, who started seeing ETF salespeople at conferences, and hearing from them at his practice, more frequently after the crisis. “That’s a really hard story to tell after ’08. Lower cost, tax efficient is a really nice story to tell.”

Most wealthy and mass affluent investors use investment advisors. The structure that had been designed to help professional investors turned out to work for retail investors, too.

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How ETFs work…

First, an ETF issuer (large or small fund company, like Vanguard or Schwab) decides to create a new ETF based on a basket of stocks (or other assets, like commodities or bonds). The basket is modeled after an index. There are millions of indexes in the world, maintained by companies of varying levels of credibility, who keep track of which stocks to put in indexes.

Then, the fund company chooses “authorized participants”—often broker-dealers—to help it. The brokers buy the underlying assets and deliver them to the ETF company in exchange for shares in the ETF. The broker then resells the shares at a premium to the public.

If demand suddenly rises to buy shares of the ETF, the broker will create more shares of the ETF, so that the price falls. If a lot of ETF owners want to sell, the broker buys shares and redeems them with the ETF issuer. The broker also has the job of keeping the price of the ETF close to the prices of the underlying assets (that’s called the NAV).

…or might not, in a crash

What happens if brokers fall down on the job, and decide to, say, quit selling if they can’t find buyers for an ETF? That’s what worries some people. The complicated structure of ETFs means there’s a potential for trading to seize up if a lot of people try to sell at once. Experts say the problem, if it happens, is likeliest in small ETFs and those that hold relatively illiquid stocks. 

But the industry is working on managing the risk, say those who aren’t so worried. “Is it a challenge? Yes it is,” says Charles D. Ellis, the founder of Greenwich Advisors. Known as the dean of American investment advisors, Ellis is sanguine about ETFs and their impact in the market. “But how big a deal is the difficulty? And, you can reduce the difficulty quite a lot with various tools, like futures.”

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The who, what, where of ETFs

ETFs took off much more quickly in the US than the rest of the world. European regulators are in the midst of adapting regulations to make it easier for ETFs to market themselves against established mutual funds.

Mutual funds still dwarf ETFs in terms of assets, despite the push for ETFs. Worldwide, there were about $17.7 trillion assets in mutual funds at the end of 2018, according to the Investment Company Institute, around five times more assets than in ETFs.

“The real reason we haven’t seen faster adoption of exchange traded products (ETPs) in Europe, and this is also applicable in the US, is because of the protection of old-school business models,” David Abner, head of capital markets for Wisdom Tree, a pioneering ETF provider, told KPMG earlier this year. “Firms don’t want to give up revenue streams to move people into lower fee, more transparent products.”

Japan has the most ETF assets by market in Asia, at ¥35 trillion (US$324.1 billion) as of June 2019. Assets expanded 3.1 times in the five years between 2014 and 2018, notable for a mature economy. Following efforts to increase product diversity, the number of ETFs listed on the Tokyo Stock Exchange reached 234 as of July 2019. The biggest contributor to growth is the Bank of Japan, which started purchasing ETFs in 2010 as a monetary policy tool to reach inflation targets. In Japan, individuals own only about 2.7% of ETF assets, according to Cerulli.

“In most Asian markets, ETFs are largely used by institutional clients compared to the retail clients,”says Leena Dagade, associate director from Cerulli’s Singapore office. “In the retail segment, the distribution model is the key hindrance apart from limited awareness of role of ETFs in portfolio construction. … The roadblock is the bank-dominated fund distribution.” 

Five giant U.S. companies dominate the global market for ETFs. They are poised to grow bigger:

Together, they owned about 90.4% of the market as of second quarter 2019, according to Cerulli and Morningstar Direct.

ETFs are experiencing a small startup boom of their own. Though it’s hard for small fund companies to compete with the low prices offered by the big firms, it’s pretty easy for someone with a little bit of experience in investing to start a fund or group of funds in an interesting area of investing. That can be anything, from, say video games to companies located in Turkey to companies with strong social justice records. If they’re successful, a bigger company stands ready to acquire the strategy, such as when Aberdeen Investments bought ETF Securities.

In the US, investment advisors continue to be the salesforce for ETFs. According to Vanguard’s Powers, about 70% of ETFs in the US are sold through advisors who work for banks, brokerages or their own firms.

Lately, new automated investing firms, or “robo-advisors,” have been selling ETFs, too. These are companies including Betterment, Wealthfront, Ellevest, and Robinhood (the last is a broker-dealer).

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What if you own ETFs?

Chances are you own one of the 10 largest, which represent broad indexes. If that’s the case, you should feel happy that you own a low-cost, diversified investment. McCarthy suggests that you’ll be a little more protected in a downturn if you diversify across investment styles and products.

“Half to three-quarters of your assets should be in indexing,” he suggests, with the rest in actively managed mutual funds.

In a downturn or a crash, you should, of course, avoid selling if you possibly can (you don’t actually lose the money until you liquidate the investment!) And keep enough cash on hand so that you don’t have to sell at a crunch time—because there certainly will be one.