The trillion-dollar ETF boom triggered by the financial crisis just keeps getting bigger

  • While ETFs first arrived in 1993, they didn’t gain in popularity until after the recession.
  • In 2008 U.S. investors had $531 billion in ETFs; that’s jumped to more than $3.4 trillion today, according to Statistica.
  • While there are still more assets in mutual funds – $18.75 trillion at the end of 2017 – ETFs continue to capture a bigger share of the market every year.

It was a decade ago that Lehman Brothers collapsed, sending markets into tailspin and causing investors to wonder if their portfolios would ever recover. While everyone knew that things would change post-crisis, no one could have predicted then that, over the next 10 years, many investors would sell off their mutual funds and buy billions of passive, index-hugging investments.

Indeed, one of the biggest stories to come out of the crisis is the rise in exchange-traded funds. While ETFs first arrived in 1993, they didn't gain in popularity until after the recession. In 2008, U.S. investors had $531 billion in ETFs; that's jumped to more than $3.4 trillion today, according to Statistica. While there are still more assets in mutual funds – $18.75 trillion at the end of 2017 – ETFs continue to capture a bigger share of the market every year.

Losing faith in mutual funds

There's a good reason why investors started turning to ETFs after the recession: They found out, the hard way, that their mutual funds weren't able to protect them on the downside. "People were disappointed that active management didn't help them," said Alex Bryan, director of passive strategies research at Morningstar. "They said that we'll be able to protect you on the downside and a lot of managers didn't deliver on that promise."

Couple that with a growing body of research that showed that active managers have trouble beating the benchmark over the long-term and investors started questioning the value that mutual funds provide.

Many investors also began wondering if their advisors, who back then were making big commissions fees off the mutual funds they sold, really had their best interests in mind. If they couldn't protect their portfolio from a 45 percent drop, which was how much the S&P 500 fell between the day Lehman collapsed and the March 9, 2009 market trough, then what was the point?

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Investors began wanting more unbiased advice, so many advisors, slowly but surely, started shifting their business to fee-only, as opposed to commission-based. Since fee-only advisors get paid by the client directly, they're free to invest in whatever they'd like. "That new business model was better built around index alternatives, because now the incentive is to keep client fees low," Bryan said. "There's less incentive to sell products with high fees because they don't get a commission."

Big players enter the market

Changing investor attitudes may have played a big role in ETF adoption, but it helped that Vanguard and BlackRock, the two largest ETF providers today, started pushing these products — which were almost exclusively tied to passive indexes — in a much bigger way right around the crisis. In 2007, the number of ETFs available jumped to 290, doubling in size and Vanguard was a big part of that. It launched its first suite of bond ETFs that year and a bevy of equity options, too.

In 2009, BlackRock purchased Barclays Global Investors, which owned the iShares brand of ETF. Barclays, which bought Lehman Brothers in 2008, was struggling financially then and needed to raise cash, so it unloaded iShares for $13.5 billion, a "fire sale" price, Bryan said. BlackRock and Vanguard, seeing the opportunity in ETFs, put huge marketing dollars behind these products and wrote investor education articles espousing the virtue of passive investments over active ones.

Soon, people across the U.S., and then the globe, started learning more about these index offerings. "Once Vanguard put its stamp of approval on ETFs, and with BlackRock doing a good job managing the iShares business, investors started taking notice," Bryan said. "The timing worked out because investors were ready for something else."

The ETF industry has continued to evolve, with more traditional asset managers, like Fidelity Investments, getting into passive in a big way. There are now more than 5,000 ETFs on the market, including ones with fees close to zero, ones that are actively managed and ones that focus on niche markets like robotics and obesity, while big players like Vanguard continue to make trading ETFs cheaper — last month the index fund and ETF giants launched commission-free trading on almost all ETFs.

Would the ETF craze have come if it weren't for the recession? Maybe, but it's developed much faster thanks to it, said Bryan. "There's a good possibility that ETFs will become the preferred investment vehicle for people," he said. "Adoption is higher now thanks to the crisis."

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