Related topics: ETF, investments, stock market, Vanguard, financial advisers
Exchange-traded funds were once an obscure niche of the mutual fund industry. No longer.
For evidence, look no further than what has happened since the markets began recovering from the global financial crisis. Since March 2009, when U.S. stock markets hit their lows, investors have pumped $57 billion into ETFs holding U.S. stocks. U.S.-stock mutual funds over the same period have suffered withdrawals of $66 billion, according to Morningstar.
In all, investors around the globe today have a total of $1.4 trillion invested in some 3,500 exchange-traded portfolios, according to BlackRock.
But ETFs, which are essentially index-tracking mutual funds that trade like stocks, have done far more than haul in cash.
For investors big and small, they have reshaped the basics of investing. They have proved easy to use for creating diversified portfolios. With relative transparency, generally low costs and tax efficiency, they offer access to markets and strategies that once were difficult to enter and exit. For professional traders, they make it possible to turn big positions on a dime, either to protect holdings or to jump on new opportunities.
In the process, ETFs have changed the way stocks and bonds trade. Buying and selling of ETF shares ripple across markets to the funds' underlying securities. Wall Street companies have reshaped their trading and sales operations to focus more on ETFs and less on individual stocks.
On any given day, ETFs are among the most actively traded securities in the U.S. markets. At the same time, however, they have opened up new potential pitfalls for investors, especially individuals.
For instance, with the ability to buy and sell over the course of the day -- as opposed to just once a day for traditional mutual funds -- ETFs raise questions about whether they make trading too easy. And some experts argue that the rush by ETF providers to grab market share has resulted in fund offerings that are not needed or are even downright dangerous for small investors.
"ETFs linked together two basic instincts," says Don Phillips, the president of fund research at Morningstar. "One was this trend toward lower costs and passive investments -- generally healthier behaviors. On the other hand, what they have tapped into is the human love of gambling -- the need for action and trading."
ETFs didn't start out as exotic instruments. The first was launched in 1993 by State Street's State Street Global Advisors with the relatively straightforward mission of tracking the Standard & Poor's 500 Index ($INX). Today, SPDR S&P 500 (SPY, news) is the largest ETF, with about $90 billion in assets.
ETFs in general trace their roots back to the pioneers of index-based investing at a division of Wells Fargo (WFC, news) in the early 1970s. That group would go on to become Barclays Global Investors, which was acquired in 2009 by BlackRock (BLK, news) and is today the biggest player in the ETF world, with $477 billion in assets in U.S.-based ETFs. The No. 3 ETF sponsor, Vanguard Group, also drew on its early experience with index mutual funds when it rolled out its first ETFs in 2001.
But as the numbers of providers and products have grown, so have the complexities of their strategies. Many promise not just to track certain indexes, for instance, but also to leverage their gains, deliver inverse returns and provide currency hedges, all to win investors looking for sophisticated tools to serve specific portfolio needs.
In the wake of the March earthquake in Japan, for example, the advantages of one highly targeted ETF were front and center for Shawn Rubin, a financial adviser at Morgan Stanley Smith Barney. Japanese stocks had fallen sharply, and Rubin thought it was time to buy. But buying foreign stocks means being exposed to swings in the country's currency -- a gamble Rubin didn't want to take,
In the past, hedging a purchase of Japanese stocks would have required taking positions in currency options to offset the exposure to the yen, which would have added to the cost of the trade for his clients. Or he could have bought a traditional mutual fund, but then he wouldn't have had clarity on exactly what stocks the fund owned and how much exposure it had to the yen's moves.
So, Rubin bought shares of WisdomTree Japan Hedged Equity ETF (DXJ), a fund designed at its launch in 2006 to track big, dividend-paying Japanese stocks but hedge away the impact of currency swings.
"ETFs have evolved in ways that help us get the exposures we want in better and better ways," Rubin says.
