Exchange Traded Funds: History, Trading, and Research

Abstract

One of the most spectacular successes in financial innovation since the advent of financial futures is probably the creation of exchange traded funds (ETFs). As index funds, they aim at replicating the performance of their benchmark indices as closely as possible. Contrary to conventional mutual funds, however, ETFs are listed on an exchange and can be traded intradaily. Issuers and exchanges set forth the diversification opportunities they provide to all types of investors at a lower cost, but also highlight their tax efficiency, transparency, and low management fees. All of these features rely on a specific “in-kind” creation and redemption principle: New shares can continuously be created by depositing a portfolio of stocks that closely approximates the holdings of the fund; similarly, investors can redeem outstanding ETF shares and receive the basket portfolio in return. Holdings are transparent since fund portfolios are disclosed at the end of the trading day. ETFs were introduced to U.S. and Canadian exchanges in the early 1990s. In the first several years, they represented a small fraction of the assets under management in index funds. However, the 132% average annual growth rate of ETF assets from 1995 through 2001 (Gastineau, 2002) illustrates the increasing importance of these instruments. The launching of Cubes in 1999 was accompanied by a spectacular growth in trading volume, making the major ETFs the most actively traded equity securities on the U.S. stock exchanges. Since then, ETF markets have continued to grow, not only in the number and variety of products, but also in terms of assets and market value. Initially, they aimed at replicating broad-based stock indices; new ETFs extended their fields to sectors, international markets, fixed-income instruments, and, lately, commodities. By the end of 2005, 453 ETFs were listed around the world, for assets worth $343 billion. In the United States, overall ETF assets totaled $296.02 billion, compared to $8.9 trillion in mutual funds.