Exchange Traded Funds: Where did they come from and where are they going?

By Emma Nelson

The speed of technological development and an anxious market forces the banking system to adapt faster and innovate further, all in the name of pleasing investors who readily take on risk to achieve any return the market will give them. And as they have time and time again, the financial industry delivers.

From the safe and dependable pass-through mortgages, to the rise of securitization in the 1970s, to the intricate technological monstrosities of credit default swaps and collateralized debt obligations that brought the economy to its knees during the financial crash of 2008, technology has a way of completely changing the landscape and rules of the market, leaving investors running to catch up.

This time, a new product is poised to become a household name just as the alphabet soup of ‘asset-backed securities’ and ‘mortgage-backed securities’ have in the past. They are known as exchange-traded funds, which only a short time ago were known only to those who traded them. What exactly are these exchange traded funds or ‘ETFs’? Simply put, ETFs are an offshoot of the typical mutual fund structure. They allow investors to trade a portfolio of securities or index just as they do shares of stock. This hybrid security seeks to mimic a benchmark, say an index like the S&P 500 or a portfolio of a specific sector in equities or bonds, as closely as possible to generate similar returns in an efficient manner. Rather than purchasing every stock of every company in the entire S&P 500 and managing that portfolio themselves, an investor can instead purchase, for example, Vanguard’s S&P 500 ETF, which will closely track the S&P 500’s return. All the investor needs to do is buy one share, which can be bought on an exchange without an exorbitant commission fee from a financial advisor, and instantly become a stakeholder in a fund that is being passively managed by companies like Vanguard and BlackRock.

The convenience of not having to pay for an actively managed fund really lies at the heart of the popularity of ETFs. While only $1 billion was invested in commodity ETFs in 2004, this value had grown to $109 billion in 2016. In fact, ETFs now comprise one-third of the entire market of publicly traded equities. With major tax advantages compared to actively-managed funds that also charge large commission fees for financial advisor input and security selection, ETFs provide portfolio diversification without exorbitant cost. By giving investors access to a vast array of investment opportunities that the average investor would not normally enjoy, such as complex derivative options, ETFs provide instant liquidity and the broad capabilities of the market through diversification of asset classes and financial instruments in a portfolio.

Every innovation comes with risk. This was no more evident than during the flash crash of 2010 when ETFs rapidly crashed after high frequency trading (highly complex and rapid computerized trading programs) sent the algorithmic trading methods utilized by investors around the world into a panic, causing the entire system to fail temporarily and resulting in devastating losses for many investors’ portfolios. Like a genetically-mutated new strain of a disease resistant to traditional cures, new technological instruments of the economy react differently to market conditions than those of the past. In the new market environment, normal relationships between asset classes have completely broken down, in part from disrupters like ETFs that grow even more complex by the day. From Leveraged ETFs that promise to deliver a multiple of the return on a given index, to synthetic ETFs that don’t even hold an underlying asset, but instead use a complex algorithm to try to match the return using derivative trading, ETFs are experiencing relentless pressure to grow more complex from a market in search of ever higher returns.

Security trading and selection in the past used to require an analyst to have a gut feeling about a certain company or the direction of a sector of the market. With the rise of ETFs and other complex investment products, investing requires a new set of skills: a keen knowledge of market fluctuations and advanced computer programming abilities, to name just a few. Meeting this demand has completely transformed the identity of Wall Street. The finance world now employs more and more PhDs with advanced mathematical and engineering degrees, especially in firms like Jane Street that mimic Silicon Valley’s commitment to intellectualism and innovation in how it operates its massive $1 billion investment fund, which specializes in these highly advanced ETF trades. These highly-educated analysts who once were derogatively nicknamed “quants” are now well-respected and integral members of any trading floor. This reversal in sentiment is ample evidence that the Street has had to evolve with advances in technology.

ETFs are the financial tool of the future, which is exactly the reason why they are so popular amongst the Millennial generation. According to one study conducted by Cogent Reports, 40% of the age group reports owning ETFs. In an interesting yet gimmicky twist, at least two investment companies are even building ETFs designed to hold shares of companies that sell to the generation born between the early 1980s and the early 2000s. This union of Millennials and ETFs makes sense: in the smartphone age, the need for a constant stream of information from investments, combined with the ease and cost of investing, make ETFs the Millennial financial tool of choice. Where Generation X and Boomers look for more traditional tools, Millennials are moving away from the wisdom of traditional market relationships and embracing the new.

It is the new, however, that often forgets the old. History has shown the great things that can be achieved with innovation, but it can also demonstrate the huge risk that underlies the foundation of many of these advancements. The changing face of Wall Street is by no means a surprise or a bad thing. Innovation brought about by these talented analysts is inevitable. However, technology outpacing our understanding of the financial world is also inevitable. There is no greater illustration of this simple fact than what we saw in the financial crisis, which was brought about not because of the new complex mortgage products on the market, but from analysts and market participants not fully comprehending how these instruments affected the macroeconomy at a fundamental level. This event was not an anomaly, but rather will continue to be the rule if risk management divisions and federal government regulation do not closely monitor these new financial tools in their introductory stages before they have a chance to wreak havoc on the financial system if something goes awry. So as ETFs grow in popularity and complexity, it is important to keep a mindful eye about the incredible potential – both positive and negative – that they can bring.