Necessity has been called the mother of invention, and perhaps no financial institution in American history illustrated this point better than the American Stock Exchange (AMEX). It began as a humble outdoor market on Broad Street in lower Manhattan, trading stocks the New York Stock Exchange (NYSE) refused to list among traders who lacked either the resources or pedigrees to gain membership to the NYSE.
By 1971, AMEX had long since moved indoors and become the second largest stock exchange in the United States (behind, of course, the NYSE), but continued to lag far behind its much larger rival. In 1977, Thomas Peterffy purchased a seat on the AMEX, founded the predecessor to Interactive Brokers, and introduced handheld computers to the trading floor. The trading floor would never be the same.
The Development of ETFs
Still, by the dawn of the 1990s, the AMEX was struggling to compete against the NYSE and the upstart NASDAQ Stock Market. Inspired by the development of program trading services that allowed institutional investors to use a single trade order to trade baskets containing many different stocks (most commonly the stocks that make up the S&P 500 Index), the AMEX developed the S&P 500 SPDR (NYSE Arca: SPY), the first successful exchange-traded fund (ETF). By the end of its first year of operations, SPY had raised $475 million in assets under management (AUM) and is currently the largest ETF in the world with approximately $268 billion in AUM.
The success of SPY set off a gold rush that continues to this date. In 1996, Morgan Stanley and Barclays Global Investors teamed up to create what would ultimately become the iShares family of ETFs, the largest issuer of ETFs today. In 2002, nine years after the launch of SPY, the burgeoning ETF industry crossed $100 billion in AUM. Nine years later, in 2011, the industry crossed $1 trillion in AUM, growing to $3.99 trillion as of July 31, 2019.
Despite the rapid growth of ETFs, many Americans remain unsure of exactly what they are. Describing ETFs as mutual funds that trade on stock exchanges, while accurate, fails to capture the benefits of ETFs that have made them such popular investment vehicles. Rather, the appeal of ETFs lies in how they differ from traditional mutual funds and how these distinctions render them attractive investment vehicles for both traders and long-term investors.
The Benefits of ETFs
The primary distinction between mutual funds and ETFs concerns the mechanism by which investors purchase and redeem shares. Mutual funds transact directly with individual investors, either selling or redeeming shares after the close of trading at the fund’s net asset value (NAV) for that day. This means that mutual funds must maintain enough cash on hand to fund any redemption requests that come in.
In contrast, ETFs trade on stock exchanges at market prices. Only large institutional investors—called “authorized participants”—trade directly with ETFs. These authorized participants make markets in ETFs on stock exchanges, creating new ETF shares when demand for them is high and redeeming ETF shares when demand for them is low. This creation-and-redemption process ensures that the market prices of ETFs generally remain close to their NAVs. In addition, ETF redemptions are handled on an in-kind basis, meaning that rather than supplying cash to redeeming authorized participants, ETFs exchange portfolio securities for the redeemed ETF shares. Consequently, ETFs do not need to maintain cash balances to fund redemption requests.
While the plumbing underlying mutual funds and ETFs may seem arcane, it carries real-world implications for traders and long-term investors alike. These implications help explain the growing popularity of ETFs and can be summarized in three words: efficiency, transparency, and flexibility.
ETFs are more efficient than mutual funds on both a cash basis and a tax basis. The cash that mutual funds must hold to fund potential redemptions creates a drag on their performance from not being fully invested. In effect, long-term investors in mutual funds bear the cost of providing liquidity to short-term traders through this cash drag. In contrast, because they redeem on an in-kind basis, ETFs have no need to hold cash to fund redemptions. Rather, authorized participants and other ETF market makers supply liquidity to short-term traders of ETFs and are compensated through the bid-ask spread. In this model, ETF market makers are middlemen, buying ETF shares at the bid (the lower price) and selling them at the ask (the higher price). The difference represents their profit and is paid by buyers and sellers of ETF shares.
From a tax perspective, because in-kind redemptions are not considered taxable transactions, ETFs can use the creation-and-redemption process to exchange out portfolio securities with a low tax basis to avoid incurring capital gains. Mutual funds, on the other hand, must generate cash to fund redemptions. When markets are going up, mutual funds tend to receive more subscriptions than redemptions and don’t need to worry about generating cash to fund redemptions. But when markets go down, mutual funds must sell portfolio holdings to raise cash, thereby generating tax consequences. Unfortunately for long-term investors, mutual funds are required to distribute taxable gains on an annual basis, meaning that investors can incur significant capital gains even if they don’t sell their mutual fund shares and are holding them at a loss. In 2018, a year that saw markets decline, more than 500 mutual funds paid out capital gains distributions in excess of 10% of their AUM.
Both mutual funds and ETFs are governed by the Investment Company Act of 1940, which mandates disclosure of portfolio holdings on a quarterly basis. ETFs, however, are subject to additional disclosure requirements as a condition of obtaining the exemptive relief from various provisions of the 1940 Act that they require to operate as ETFs. As a practical matter, this means that ETFs—with a few unique exceptions—are required to disclose their portfolio holdings daily, thereby providing greater transparency to investors.
Investors may buy or sell mutual fund shares once per business day after the close of trading. While mutual funds transact at NAV, investors have no way of knowing exactly what the fund’s NAV will be when they enter a buy or sell order. In contrast, because ETFs trade on stock exchanges, investors can buy and sell them throughout the day and can specify the prices at which they are willing to do so. They can also sell them short or use them in margin accounts to enhance their buying power.
The Future of ETFs
With more than $20 trillion in AUM as of July 31, 2019, mutual funds remain the most popular investment vehicle for individual investors. But their lead over ETFs has been steadily whittled away over the past 20 years. At the turn of the century, mutual funds held about 200 times more AUM than ETFs. Today, the ETF industry has grown to one-fifth the size of the mutual fund industry and many observers predict ETFs will ultimately overtake mutual funds as the preferred investment vehicle for individual investors as more and more people come to realize the benefits afforded by the ETF structure.