Definition and history of

Introduction – What is an ETF

An ETF is an “exchange-traded fund”, in other words, a 1933 act fund (like those you find in your Vanguard or Fidelity retirement accounts), but whose units happen to be listed on a stock exchange like a regular stock. 

More importantly, the investment process into such a fund doesn’t happen through the usual unit purchase process (call or instruction, money deposit, unit delivery to a custodian…). 

Instead, 

  1. the investor buys existing units on the exchange, 
  2. while the market-makers offering these units on the exchange are the only market participants authorized to create units with the fund.
  3. Those market participants deliver a basket of shares and receive fund units (ETFs) in return.

There are many consequences following this original process.

History of ETFs

The first ETFs appeared in the early 1990’s, but you have to wait for the 2000’s to see a significant growth in their AUM. Nowadays, there are over 7,500 different ETFs globally, and they are listed on most major exchanges. With an estimated $8 trillion of assets globally, they have a wide diversity of underlying classes, countries, indices, and investment themes. They have also seriously dented the classic business.

Justice
Number of ETFs 2003-2021

A few numbers

Here are the interesting figures about ETFs:

AUM of US Passive funds in 2019
  • Meanwhile, ETF AUM will surpass passive mutual fund AUM in the coming years, if it hasn’t already. Here are the global ETF vs Passive AUM as of 2019:

 

Index Fund and ETF AUMs
  • The main investment players form the very small trillion + club. You will find: 
    • Vanguard with ~50% of the passive funds, and only at 25% of the ETF market. 
    • BlackRock (iShares) with 20% of the mutual fund business but close to 40% of that ETF market. 
    • State Street with 8% of the Mutual fund business and ~15% of ETFs. 

Market share - Passive vs ETFs
  • The ETF industry is also very concentrated in terms of which ETFs manage most of the AUM. The top 20 ETFs manage half the AUM of the industry.
  • You can trade ETFs like any stock, and own them on margin. While classic mutual funds can only be created once in the day at the fund’s close, ETFs can be purchased all day long, anr you have therefore a much better control of the price you are paying. You can give the whole range of instructions to your broker – market/limit order, average, market-on-close, market-on-open… 
  • They are generally highly liquid instruments. The SPY is the most liquid and most highly traded stock in the world. ETFs also have what is called a “hidden liquidity” as market-makers can jump in and provide liquidity when a sudden strong demand or offer makes their prices deviate from their theoretical value.
  • They are tax-efficient, an issue we will come back to. That tax efficiency comes from two factors: their large AUM and low turnover, which allows the fund managers to rarely sell their shares, as well as their atypical creation/ process.
  • There are options on many of these ETFs. Highly liquid options.
  • ETF management is a highly competitive business, where the level of the management fees drive inflows and outflows. Needless to say, the mutual fund industry has been in a permanent mode of cost-cutting as a result.

The reasons for the growth

How did we arrive there? This astonishing growth comes from several factors:

  1. Many academic papers (and Nobel prize-winning papers) have demonstrated that most of the return of an asset comes from its class, and in the equity space, from its sector. The idiosyncratic benefit of a given stock (the specificity of the stock) exists, but it is on average relatively modest. Simply said, you won’t gain many benefits in your portfolio by replacing Exxon by Chevron, or Visa by Mastercard.
  2. Many mutual funds underperform their benchmarks (the market index they refer to), and that statement is particularly true after fees. Actually, very few portfolio managers constantly outperform their target on a consistent basis. Their relatively high management fees, a 1% or so, was actually their only real consistency.
  3. So why pay large fees for a fund, who tracks the market and will rarely outperform it?

John Bogle

And so in 1975, an American called John Bogle created the first index-based mutual funds. That would be a mutual fund whose objective was only to replicate the market, for a reduced fee. It was laughed at by the competitors, who called it “Un-American”. It only had $11m in its first year. Haha. That fund, eventually renamed Vanguard, eventually passed the $100 billion mark in 1999. Haha.

The listing of these funds further facilitated their distribution to an even larger audience, by allowing almost everybody to invest into the fund. The creation/redemption process associated with the listing, not only added tax benefits, but it allowed the price of the fund units to be close to the fund’s value, thanks to the presence of arbitragers. We will come back on all these terms and concepts.

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