How Exchange-traded Funds Came to Be

Though creation of the modern exchange-traded fund (ETF) quite was begun in Toronto in 1989, the origins of the ETF stretch back to 1976; that year saw the first index fund, a brainchild of the Vanguard Group’s John C. Bogle. Bogle conducted a study showing that 75% of extant mutual funds earned as the same or less than the Standard & Poor 500 stock market index. Bogle’s reasoning therefore ran: If a mutual fund invested in the entire Standard & Poor’s 500, such a mutual fund would automatically be advantageous over the standard mutual fund. Thus was created the Vanguard 500.

The ETF is a natural outgrowth of the index fund in characteristic as an open-ended collective investment, with a few changes due to modern exchange dynamics. Similarly to investment companies, ETFs are registered with the Securities and Exchange Commission as a company. After creation of the ETF, the institutional investor deposits a block of securities; in exchange, the institutional investor gets ETF shares which may be traded on the stock exchange.

As in index funds, investors are deal with blocks of stocks in trying to regulate the stock market index; this reduces risk due to the anchoring effect of blue-chip stocks while taking advantage of boom times. ETFs can also be based in a market sector or a commodity. Unlike mutual funds, an ETF’s individual shares and index funds are not redeemable in part.

A recent addition to ETF investment schemes in America is exemptive relief. This allows registration of an ETF as a mutual fund despite non-individually redeemable nature, the trading of shares in kind is permitted, with share prices pre-negotiated. The advantage here is that, since ETF are traded intraday only, the market-determined prices can protect investors from days of dramatically fluctuating trade.

Since its introduction to the Canadian market in 1990 and the American three years later, the ETF has ballooned in popularity, evolving from a little-known alternate to open-ended index funds to an investment industry in and of itself. The Toronto Stock Exchange released the first ETF, dubbed “TIPS.”

In America released of a like product required a fair bit of finagling with the SEC and investigating American federal law (e.g. laws regulating mutual funds such as the 1933 Securities Act, the 1940 Securities Exchange Act of 1940), January 1993 saw the release of the first American ETF, the S&P Depository Receipts (commonly called “SPDRs”) Trust Series, which was based on the Standard & Poor 500 index. The second US ETF arrived in 1995 and was based on the S&P MidCap 400 index was added.

The popularity of ETFs soon began its steady increase. In 1996, 17 ETFs based on international stock exchanges came out. In 1998, Select Sector SPDRs came out. Stock exchanges worldwide began to respond. In 1999, ETFs were released on the Tokyo Stock Exchange. In 2001, an agreement between TSE and the American Stock Exchange allowed cross listing and trading of ETFs between the two countries.

In fact, internationally, 2001 proved the defining year for ETFs. In July of that year, the Australian Stock Exchange introduced an new trading platform designed especially for listed investment funds in response to the ETF market. Stock markets in Japan, Hong Kong and Canada introduced numerous variants on the ETF. The investment scheme generally caught quickly outside North America, and market assets grew by 43% that year.

European Union bureaucracy is often blamed for the late release of European ETFs, with two European ETFs introduced in 2001: SPDR Europe 350 and SPDR Euro. By December, however, a whopping sixty-one ETFs were listed on the European market, ETF assets were over US $3.6 billion, and an increase of 58% from second to third quarter was seen. ETFs were rapidly unveiled in each of the EU 15 countries and ETF markets have been constructed in new EU member states, though ETFs have not been released there yet.

In this decade, ETF assets have grown at amazing rates. In 2001, assets of the under 90 ETFs were approximately US $83 billion. In 2003 and 2004, assets were $150 billion-plus and US $225 billion-plus respectively, approximately 33% compounded annually. As of December 2005, over 170 ETFs in 28 represent a combined US $230 billion-plus in assets.

With this explosive growth came innovation. In November 2004, two-century-old State Street Corporation launched a new version of the ETF called “StreetTracks Gold Shares.” This ETF represented the first to track a commodity; estimates have StreetTracks ETFs amassing some US $1.5 billion in assets within one month.

Figures from March 2005 show that ETF assets represented almost US $230 billion of the US $8 trillion mutual funds market. One hundred sixty-two exchange-traded funds existed, with 110 extant ETFs tied in to domestic stock indexes for just under US $180 billion; sixty-seven of these featured broad indexes and represented over 88% of US ETF assets. Forty-six international ETFs represented US $37.7 billion in worth, and six ETFs followed bond indexes and were worth over US $11 billion.

And ETF market growth continues; in April 2006 alone, significant events further shaped possibilities in ETFs. Shenzen Stock Exchange, one of China’s two stock exchanges, saw its first ETF on April 24. The Shanghai Stock Exchange had released an ETF one year previously. In America, about a week prior to the new Chinese ETF, Chicago index firm IPOX Schuster released the First Trust IPOX-100 Index Fund, the first ETF to reflect initial public offerings on the U.S. market.

Finally, the London Stock Exchange announced the imminent introduction of the ETF Securities fund, a scheme that seeks to bring small investors into the ETF fold. ETF Securities is a combination of commodities; rumor says ETF Securities was created in response to the surging of copper, zinc, silver and, to some extent, oil. While German, American and British investment brokers feature a number of mixed commodity index funds, the ETF Securities fund is promised to require smaller capital investment to earn returns on investment.

By the time you read, the ETF market is soon to have undergone further changes. And the scrupulous investor will have noticed, for few markets are as vibrant as that of ETFs.

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