An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product; i.e., it is bought and sold on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, cryptocurrency, debt, futures contracts, and/or commodities such as gold bars. ETFs provide more diversification than owning an individual stock and more market liquidity than owning an individual bond.

Most equity and fixed-income ETFs are index funds; they use passive management to replicate the performance of a stock market index or bond market index. These indices can be broad-based, such as the S&P 500 or focus on a certain industry such as the technology industry or the financial industry, a certain quality such as growth stocks or value stocks, a certain market capitalization, a certain factor such as high dividend stocks or value, momentum, quality, and low volatility, or a certain theme such as climate change, cloud computing, robotics, electric vehicles, the gig economy, e-commerce, or renewable energy. Other ETFs use active management, either by picking stocks or by the use of covered call strategies to generate income. For ETFs that invest in bonds, some will focus on government bonds, while others invest in corporate bonds or high-yield debt or focus on specific durations. Some ETFs use buffer strategies to reduce both risk and reward.

ETF issuers are required by regulators to publish the composition of their portfolios on their websites daily, or quarterly in the case of active non-transparent ETFs. ETFs are priced continuously throughout the trading day.

ETF issuers charge annual expense ratios that are as low as 0.02% of the investment value, but can be much higher for ETFs that focus on a niche. Trading in ETFs may be subject to stockbroker commissions and financial transaction taxes.

ETFs can be sold short, can be purchased using funds borrowed from a stockbroker (margin), and can be purchased and sold using limit orders, with the buyer or seller aware of the price per share in advance. Options, including put options and call options, can be written or purchased on many ETFs.

ETF investors generally only realize capital gains taxes when they sell their own shares for a gain, making them more attractive tax-wise than mutual funds in some cases.

ETFs have similarities to mutual funds, closed-end funds, and exchange-traded notes. ETFs are regulated by governmental bodies and are subject to securities laws.

Statistics

The United States is by far the largest market for ETFs. In the United States, there is $10.2trillion invested in equity ETFs, $2.4trillion invested in fixed-income ETFs, and $0.6trillion invested in other ETFs. In Europe, there is $1.4trillion invested in equity ETFs, $0.7trillion invested in fixed-income ETFs, and $0.1trillion invested in other ETFs. In Asia, there is $1.9trillion invested in equity ETFs and $0.2trillion invested in fixed-income ETFs. Trading in ETFs accounts for approximately one-third of the total dollar volume of stock market trading in the US, 11% of trading volume in Europe, and 13% of trading volume in Asia. Purchases and sales of underlying assets by ETFs can significantly affect the price of such underlying assets.

In the United States, the largest ETF issuers by assets are BlackRock iShares with a 29.5% market share, Vanguard with a 28.7% market share, State Street Global Advisors with a 13.4% market share, Invesco with a 5% market share, and Charles Schwab with a 4% market share.

Legal structure

An ETF divides ownership of itself into shares that are held by shareholders. Depending on the country, the legal structure of an ETF can be a corporation, trust, open-end management investment company, or unit investment trust. Shareholders indirectly own the assets of the fund and are entitled to a share of the profits, such as interest or dividends, and would be entitled to any residual value if the fund undergoes liquidation. Shareholders also receive annual reports. An ETF generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occur.

ETFs that invest in commodities are generally structured as exchange-traded grantor trusts, which gives a direct interest in a fixed portfolio. SPDR Gold Shares, a gold exchange-traded fund, is a grantor trust, and each share represents ownership of one-tenth of an ounce of gold.

ETFs offered by Vanguard are actually a different share class of its mutual funds and do not stand on their own; however, they generally do not have any adverse tax issues.

Investment structure

Most index ETFs invest 100% of their assets proportionately in the securities or assets that they intend to track, a manner of investing called replication. However, some ETFs instead use derivatives such as futures contracts, options, and swaps to track the underlying assets for all or a portion of their portfolios. This can lead to tracking error and may introduce counterparty risk. ETFs that engage in such practices include the Vanguard Total Stock Market Index Fund, the United States Oil Fund, some cryptocurrency ETFs, and synthetic ETFs.

Leveraged ETFs (LETFs) and inverse ETFs, such as those issued by Direxion, use various financial engineering techniques, including equity swaps, derivatives, futures contracts, rebalancing, and re-indexing to seek a daily return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of an index with the result of significantly amplifying both risk and return. These funds must undergo daily rebalancing, selling after losses and buying after gains, and therefore are subject to volatility tax.

Arbitrage mechanism

ETF shares are created and redeemed when large broker-dealers called authorized participants (APs) act as market makers and purchase and redeem ETF shares directly from the ETF issuer in large blocks, generally 50,000 shares, called creation units. Purchases and redemptions of the creation units are generally in kind, with the AP contributing or receiving securities of the same type and proportion held by the ETF; the lists of ETF holdings are published online.

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. APs provide market liquidity for the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares on the secondary market.

If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF issuer and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from their net asset value.

When new shares of an ETF are created due to increased demand, this is referred to as ETF inflows. When ETF shares are converted into the component securities, this is referred to as ETF outflow.

ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value.

History

ETFs had their genesis in 1989 with Index Participation Shares (IPS), an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States. The argument against the IPS approach was that it resembled a futures contract because the investments held an index, rather than holding the actual underlying stocks.

In 1990, a similar product, Toronto Index Participation Units, which tracked the TSE 35 and later the TSE 100 indices, started trading on the Toronto Stock Exchange (TSE) in 1990. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy regulations by the U.S. Securities and Exchange Commission.

Nathan Most and Steven Bloom, under the direction of Ivers Riley, and with the assistance of Kathleen Moriarty, designed and developed Standard & Poor's Depositary Receipts (NYSE Arca: ), which were introduced in January 1993. Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995, State Street Global Advisors introduced the S&P 400 MidCap SPDRs (NYSE Arca: ).

It is a frequent topic in the financial press that ETFs have a quick growth. These popular funds, with assets more than doubling each year since 1995 (as of 2001), have been warmly embraced by most advocates of low–cost index funds. Vanguard is the leading advocate of index funds.

Barclays, in conjunction with MSCI and Funds Distributor Inc., entered the market in 1996 with World Equity Benchmark Shares (WEBS), which became iShares MSCI Index Fund Shares. WEBS originally tracked 17 MSCI country indices managed by the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.

In 1998, State Street Global Advisors introduced "Sector Spiders", separate ETFs for each of the sectors of the S&P 500. Also in 1998, the "Dow Diamonds" (NYSE Arca: ) were introduced, tracking the Dow Jones Industrial Average. In 1999, the influential "cubes" was launched, with the goal of replicating the price movement of the NASDAQ-100 – originally QQQQ but later Nasdaq: .

The iShares line was launched in early 2000. By 2005, it had a 44% market share of ETF assets under management. Barclays Global Investors was sold to BlackRock in 2009.

In 2001, The Vanguard Group entered the market by launching the Vanguard Total Stock Market ETF (NYSE Arca: ), which owns every publicly traded stock in the United States. Some of Vanguard's ETFs are a share class of an existing mutual fund.

iShares issued the first bond funds in July 2002: iShares IBoxx $ Invest Grade Corp Bond Fund (NYSE Arca: ), which owns corporate bonds, and a TIPS fund. In 2007, iShares introduced an ETF that owns high-yield debt and an ETF that owns municipal bonds and State Street Global Advisors and The Vanguard Group also issued bond ETFs.

In December 2005, Rydex (now Invesco) launched the first currency ETF, the Euro Currency Trust (NYSE Arca: ), which tracked the value of the Euro. In 2007, Deutsche Bank's db x-trackers launched the EONIA Total Return Index ETF in Frankfurt tracking the Euro. In 2008, it launched the Sterling Money Market ETF (LSE: ) and US Dollar Money Market ETF (LSE: ) in London. In November 2009, ETF Securities launched the world's largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies.

The first leveraged ETF was issued by ProShares in 2006.

In 2008, the SEC authorized the creation of ETFs that use active management strategies. Bear Stearns launched the first actively managed ETF, the Current Yield ETF (NYSE Arca: ), which began trading on the American Stock Exchange on March 25, 2008.

In December 2014, assets under management by U.S. ETFs reached $2 trillion. By November 2019, assets under management by U.S. ETFs reached $4 trillion. Assets under management by U.S. ETFs grew to $5.5 trillion by January 2021.

ProShares Bitcoin Strategy ETF, launched in October 2021, was the first ETF to track the price of Bitcoin; it invested in futures contracts. After legal cases that mandated approval by the United States Securities and Exchange Commission, the first ETFs to own spot bitcoin began trading in January 2024.

In October 2023, ProShares, VanEck and Bitwise Asset Management launched the first ETFs tied to the value of Ethereum; these ETFs invested in futures contracts. The first spot ETFs that own Ethereum began trading in May 2024; the United States Securities and Exchange Commission set the condition that the ETFs were not allowed to claim rewards on their coins from the proof-of-stake process, which eliminated a possible source of income.

Gold ETFs

The first gold exchange-traded product was Central Fund of Canada, a closed-end fund founded in 1961. It amended its articles of incorporation in 1983 to provide investors with a product for ownership of gold and silver bullion. It has been listed on the Toronto Stock Exchange since 1966 and the American Stock Exchange since 1986.

The idea of a gold ETF was first conceptualized by Benchmark Asset Management Company Private Ltd in India, which filed a proposal with the Securities and Exchange Board of India in May 2002. In March 2007 after delays in obtaining regulatory approval. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. SPDR Gold Shares, a commodity ETF, is the largest gold ETF and one of the largest ETFs by assets under management.

European market adoption and perception

Since the first European ETF appeared in 2000, the market has seen tremendous growth. At the end of March 2019, assets under management (AUM) stood at €760billion, compared with €100billion at the end of 2008. The market share of ETFs also increased, accounting for 8.6% of AUM, up from 5.5% five years earlier.

The use of ETFs has also evolved over time. EDHEC business school surveys show greater adoption, especially for traditional asset classes. While ETFs are now used across many asset classes, in 2019, the main use was in the area of equities and sectors, for 91% (45% in 2006) and 83% of the survey respondents, respectively. This is likely to be linked to the popularity of indexing in these asset classes and the fact that equity indices and sector indices are based on highly liquid instruments, which makes it straightforward to create ETFs on such underlying securities. The other asset classes for which many investors use ETFs are commodities and corporate bonds (68% for them both, compared with 6% and 15% in 2006, respectively), smart beta-factor investing, and government bonds (66% for them both, compared with 13% for government bonds in 2006). Investors have a high rate of satisfaction with ETFs (95% for both equities and government bond assets in 2019).

Asset allocation

EDHEC survey results indicate that ETFs are used as part of a truly passive investment approach, mainly for long-term buy-and-hold investment rather than tactical allocation. However, the two approaches have become more balanced, and, in 2019, European investment professionals declared that their use of ETFs for tactical allocation was greater than for long-term positions (53% and 51%, respectively).

ETFs, which originally replicated broad market indices, are now available in a variety of asset classes and many market sub-segments (sectors, styles, etc.). Gaining broad market exposure was the focus of ETFs for 73% of users in 2019, but 52% of respondents aimed to use ETFs to obtain specific sub-segment exposure. The diversity of products increases the possibilities for using ETFs for tactical allocation. Investors can easily increase or decrease their portfolio exposure to a specific style, sector, or factor at a lower cost with ETFs. The more volatile the markets are, the more interesting it is to use low-cost instruments for tactical allocation, especially since cost is a major criterion for selecting an ETF provider for 88% of respondents.

Recent developments

Despite the maturity of the European market in 2019, many investors (46%) were planning to increase their use of ETFs, according to the EDHEC 2019 survey. A higher level of ETF allocation would replace active managers (71% of respondents), but investors were also seeking to replace other passive investing products (42% of respondents). Lowering costs was the motivation for these changes for 74% of investors. They also wanted more ETF products in the areas of ethical, socially responsible investing, and for strategies using factor and smart beta indices. In 2018, Environmental, social, and governance (ESG) ETFs enjoyed growth of 50%, reaching €9.95 billion, with the launch of 36 products, compared to 15 in 2017. However, 31% of the EDHEC survey respondents still wanted more ETF products based on sustainable investment, which appeared to be their top concern. By late 2024, ESG ETFs reached over $640 billion in assets.

ETFs by asset size (US$1000)
ETFs by asset size (US$1000) - as of date unknown, unsourced

Notable issuers

See also

Further reading

  • Carrell, Lawrence. ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing. Wiley, September 9, 2008. ISBN 978-0-470-13894-6
  • Ferri, Richard A. The ETF Book: All You Need to Know About Exchange-Traded Funds. Wiley, January 4, 2011. ISBN 0-470-53746-9
  • Humphries, William. Leveraged ETFs: The Trojan Horse Has Passed the Margin-Rule Gates. 34 Seattle U.L. Rev. 299 (August 31, 2010), available at .
  • Koesterich, Russ. The ETF Strategist: Balancing Risk and Reward for Superior Returns. Penguin Books, May 29, 2008. ISBN 978-1-59184-207-1
  • Lemke, Thomas P.; Lins, Gerald T. & McGuire, W. John. Regulation of Exchange-Traded Funds. LexisNexis, 2015. ISBN 978-0-7698-9131-6

External links