Exchange Traded Funds (ETFs) have evolved into widely used investment vehicles for retail and institutional investors alike. The first generation of ETFs were focused on low-cost and passive investing that tracked stock market indexes. Over the past 20 years, ETFs have gained more popularity due to their low-cost, daily liquidity, tax efficiency, and ease of use. The widespread use of ETFs has resulted in over $9 trillion in ETFs with new ETFs being launched daily. This article will explore the history of ETFs, their structure, popular growth, and benefits.
History and regulation: The first ETFs were launched in 1993. The purpose of these first generation of ETFs was to provide passive exposure to equity indexes at a low-cost. The first fixed-income ETF didn’t arrive until 2002. The first actively managed ETF didn’t arrive until 2008. ETFs are regulated by the Securities and Exchange Commission (SEC). The SEC’s Division of Investment Management regulates the companies that issue ETFs while the SEC’s Division of Trading and Markets regulates the trading component of ETFs. Due to the SEC regulation, both divisions require ETFs to comply with certain rules, disclosures, and filings. Similar to mutual funds, all ETFs must file a prospectus.
Structure: ETFs are pooled investment vehicles with shares that trade intraday on stock market exchanges at a market price. The creation of ETF shares is unique, and different than mutual funds. For ETFs, an Authorized Participant (AP), such as a large bank, provides a specific basket of securities to the ETF issuer. Then, the Authorized Participant, receives a fixed number of shares in return which may be sold on a stock exchange. Therefore, the Authorized Participants act as the role of “market makers” in the trading process. The AP must be US-registered, self-clearing broker-dealers who can process the full duration of a trade including trade submission, clearance and settlement. Further, the AP must be members of the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC). Examples of an AP include Bank of America, Goldman Sachs, and JP Morgan.
Competitive Returns: Part of the increasing popularity of ETFs is their competitive returns in some asset classes where market efficiency is largely believed to persist. One of those assets classes is U.S. large cap equities. The graphic below shows the percentage of “active” managers who underperform the S&P 500 each year.
As seen in the chart, over the past 20+ years, there are consistently 55%-65% of active funds that underperform the S&P 500 each year. Further, while an active fund may outperform in one year, the challenge lies with that same active fund outperforming on a consistent basis. Due to that, passively managed large-cap ETFs such as iShares Core S&P 500 ETF (IVV), SPDR S&P 500 ETF (SPY), and Vanguard S&P 500 ETF (VOO) all rank in the top quartile peer ranking (top 25%) across 3-year, 5-year, and 10-year periods. That performance ranking consistency, coupled with very low costs, results in ETFs being a suitable investment for investors looking for a large-cap equity holding. Landing Point Financial Group has consistently used IVV in their clients’ portfolios.
Lower Cost and Tax Efficiency: Compared to mutual funds, ETFs generally have lower total costs due to their mostly passively managed approach coupled with fewer trading costs. Another advantage of ETFs (compared to mutual funds) is the tax efficiency they provide to investors. The tax efficiency is due to how ETFs are structured, the lack of taxable events, and less portfolio turnover. ETFs generally have fewer capital gains distributions compared to mutual funds. Mutual funds are challenged with selling securities at a profit, then passing along the capital gains, and associated taxes to the shareholders. However, ETFs have an in-kind redemption process that results in tax efficiency. When an investor sells an ETF, the shares are usually transferred directly to a buyer and therefore ETFs are not forced to sell securities to raise cash. Based on research from Morningstar, only 2.5% of all ETFs distributed capital gains in 2023 compared to 31.5% for mutual funds.
ETF Types: ETFs were focused on passive U.S. equity investing in the early days. Since then, ETFs have evolved and now provide access to a wide range of asset classes and geographies. There are three broad types of ETFs: passive, active, and strategic beta:
1) Passive ETFs allows investors to gain a similar exposure to a corresponding index, such as the S&P 500.
2) Active ETFs give investment professionals the freedom to pursue a specific portfolio based on their proprietary research and analysis. These types of ETFs allow investors the opportunity to pursue additional gains (or losses) that may not be available from passively managed ETFs. The active and human element allows for more flexibility in the portfolio construction process.
3) Strategic Beta ETFs are often a subset of a larger investable universe. Frequently, these types of ETFs use a “factor” to determine the portfolio construction. Common factors include market size, valuation, dividends, momentum, minimum volatility, and high-quality earnings. Strategic beta ETFs often use a rules-based approach where screens are built with specific thresholds for those factors. The companies that pass through those pre-determined screens are included in the portfolio.
ETFs aim to replicate the performance of a specific market segment, such as an asset class (bonds), geography (Europe), sector (financial), or investment theme (sustainability). All three types of ETFs cover the global investable universe. For instance, investors can purchase ETFs across major asset classes including equity, bonds, commodities, and alternatives. Further, the sub-asset classes are extensive too as ETF investors can invest in the following sub-categories within bonds; mortgage-backed securities, inflation protected, high yield, municipal, ultra-short, bank loans, emerging markets bonds, corporate, and government (equities, commodities, and alternatives also have a variety of sub-asset classes to invest it).
The wide range of ETF options allow investors to use them for a variety of reasons including the following:
- Diversify across strategies, geographies, and strategies
- Attempt to outperform the broader market
- Invest in promising sectors, themes, and industries
- Gain exposure to an index
- Access hard to reach markets
- Manage risk
Growth: The ETF industry started in 1993 with a single ETF. The first ETF was the State Street Global Advisors SPDR S&P 500 ETF Trust (SPY). Since then, the use of ETFs has grown exponentially. There were 18 ETFs in 1997, 526 ETFs in 2008, 1,203 ETFs in 2015, and over 3,000 ETFs in 2024. As the number of ETFs proliferated, so did the total assets under management (AUM). The chart below shows the growth in AUM for ETFs (source: U.S. Federal Reserve Bank of St. Louis).
ETF Risks: There are risks and challenges to ETFs due to their prolific growth. First, the rapid growth of ETFs has led to very niche, complex, and high-risk ETFs that may not be appropriate for many investors. For instance, leveraged ETFs will magnify the gains or losses of an underlying index up to 4x. For instance, if the S&P 500 returns -15%, then a corresponding 4x S&P 500 ETF would return approximately -60%. Another risk of ETFs is tracking error risk. This is the risk that the returns of an ETF do not perfectly mimic the returns of the underlying index it is tracking. There is often some minor tracking error associated with ETFs due to the timing of dividends, taxes, and fees. Investors should be aware of and understand any tracking error when reviewing an ETF.
Summary: Exchange Traded Funds (ETFs) will continue to be a significant part of an investor’s portfolio. They have several key financial benefits including a low-cost structure and tax efficiency that can make ETFs attractive investments compared to mutual funds. Beyond the financial benefits, ETFs can provide investors with access to very broad or very specific asset segments that investors are often looking for.
At Landing Point Financial Group (LPFG), we aspire to stay current with the changing landscape of investment products and strategies. We will continue to monitor the ETF landscape for new investment opportunities that may be appropriate for clients. Several ETFs are used in our seven proprietary investment models in larger and more efficient markets (i.e., U.S. large-cap stocks and U.S. mid-cap stocks).
We are excited about the opportunity and challenge of finding better investment opportunities for our clients. There is a sense of satisfaction and achievement that comes with finding an investment opportunity that has the potential to add-value to a client’s portfolio – this is our goal! However, we are acutely and humbly aware that finding a new investment opportunity is just a part of our entire investment process.
Past performance is no guarantee of future results. No client should assume that future performance of any securities, asset classes, or strategies will be profitable, or equal to the previous described performance. The material has been gathered from sources believe to be reliable, however, Landing Point Financial Group cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. To determine which investments may be appropriate for you, consult your financial adviser prior to investing. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional.