Last Updated on September 28, 2023
ETFs stands for Exchange-Traded Fund, a popular and innovative investment vehicle. It allows you to invest in a diversified asset portfolio, including bonds, stocks, currency, etc.
ETFs are structurally similar to mutual funds, with the main difference being that they are tradable on a stock exchange. As a result, they are easy to buy and sell.
However, this has not always been the case. In fact, ETFs are one of the newest asset classes.
This article will explore in detail the history of ETFs, tracing their origin, growth, and impact in the investment landscape.
Exchange Traded Funds History and Early Development
ETFs first came into existence in May 1989 in the United States. The first one, Index Participation Shares, tracked the Standard & Poor’s index of the largest 500 publicly traded companies.
The S&P 500 remains the key index that Exchange-Traded Funds track.
However, at the time, Chicago courts ruled that these instruments were actually futures. Hence they were only available on futures exchanges.
Following the same idea, the next iteration was on the Toronto Stock Exchange in 1990. They released the Toronto 35 Index Participation Units (TIP 35). It eventually expanded with the addition of the TIP 100 shares.
The success of these early Exchange-Traded Funds in Canada spurred American investment experts to try to introduce ETFs again in 1993 under the form of S&P Depositary Receipts.
Traders sometimes also call them the SPDRs or Spiders. To date, they remain among the most tradable ETFs.
The popularity of the ETF market has been climbing steadily since its inception. In the United States, the total net assets of ETFs were approximately $6.44 trillion in 2022 – a major increase from only $102 billion in 2002.
How Do ETFs work?
ETFs offer the opportunity to invest in a basket of assets, including buying whole indexes that would have otherwise proven extremely costly. That way, investors can create a diversified portfolio, while also benefiting from the performance of the entire index for a significantly lower price.
Compared to traditional mutual funds, it trades like a regular stock on the stock exchange. The price of ETFs fluctuates throughout the day, like any other stock, based on buying and selling activity.
The value of the Exchange-Traded Funds is determined by the net asset value of the underlying constituents plus any cash that it holds. Any existing liabilities are then deducted and the sum is divided by the number of ETF shares outstanding.
What Are the Main Types of ETFs?
There are several types of ETFs available for investors which can be used to generate income, speculate, and hedge against risk.
Here are some of them:
Equity ETFs
Equity Exchange-Traded Funds invest in a diversified stock portfolio representing a particular sector, industry, region, or market index.
These funds track the performance of the underlying equity index and provide investors with exposure to a diverse range of companies.
Fixed-Income ETFs
Fixed-income ETFs, also known as bond ETFs, are investments in a collection of fixed-income securities. They include government, corporate, or municipal bonds.
Commodity ETFs
These ETFs involve investment in physical or virtual commodities, including silver, oil, gold, or agricultural products. Mostly, these ETFs cover commodity futures contracts.
Commodity ETFs allow investors to partake in the price movements of commodities without owning any of the physical assets directly.
Currency ETFs
These funds invest in currency futures contracts and offer exposure to the foreign exchange market.
Traders often use them to speculate on the prices of currencies according to a country’s economic or political developments.
Inverse and Leveraged ETFs
Inverse ETFs have an inverse relationship with the performance of the underlying asset. The funds use derivatives to short a stock, and attempt to make gains from a stock’s decline.
This makes them suitable for investors seeking to profit from market declines.
Leveraged ETFs, on the other hand, amplify the performance of the underlying index with values of 2x, 3x, or more.
What Are the Benefits of ETFs?
ETFs have several benefits, including:
- Diversification: ETFs offer investors access to a diversified portfolio, thereby reducing the risk of individual assets.
- Liquidity: ETFs offer liquidity and flexibility as they trade on stock exchanges throughout the day, and you can buy or sell at any time.
- Lower costs: ETFs are very cost-effective investments as they have lower expense ratios compared to mutual funds.
What Are the Limitations of ETFs?
While ETFs offer a lot of investment benefits for investors, they also have some drawbacks, such as:
- Higher fees: Trading ETFs frequently can result in higher brokerage fees and commissions, which can consequently reduce overall returns.
- Limited Diversification: ETFs may limit investors to large-cap stocks in specific foreign markets or sectors. This will make them miss out on growth opportunities.
How to Buy ETFs?
Take the following steps to start buying ETFs:
- Open a brokerage account with a reputable financial institution with access to various ETFs.
- Conduct thorough research to identify ETFs that align with your investment goals, preferences, and risk tolerance.
- Set up your investment plan and decide on the amount you want to invest.
- Purchase the ETF you have selected using your brokerage account.
- Consistently track, manage, and adjust your investment portfolio.
- Stick to your exit strategy.
You may also like: The Importance of Cutting Your Losses: Learn When to Exit a Trade
Takeaway: Exchange-Traded Funds Are a Convenient Investment Vehicle
ETFs provide diversification, lower costs, and liquidity benefits. They offer access to a wide range of asset classes and sectors. This makes them suitable for various investment strategies.
While Exchange-Traded funds have numerous benefits, they also have some limitations and, as an investor, you should be cautious of them.
All in all, ETFs are among the most efficient and convenient means to participate in financial markets.
