In 2008, U.S. investors had around $530 billion in ETFs. Today, that number has grown to over $4 trillion.
The exchange-traded fund, or ETF, first arrived in 1993, but has seen its biggest gains in popularity after the '08 recession. How and why did that shift happen?
More than a decade ago, the financial crisis changed the markets. Lehman Brothers, an investment bank that was over 150 years old, collapsed when the federal government decided not to bail it out. Markets dove and trillions of dollars were wiped out in a matter of months. With passively managed index funds already having swelled in popularity ever since Vanguard created the first in the 1970s, everyday investors had even more reason to question the performance of their actively managed portfolios, which charged high fees and failed to deliver better performance than low-cost index funds.
Over the next 10 years, many investors would leave their actively managed portfolios and move billions into the newest form of index funds: ETFs.
ETFs, like most investment funds, including traditional index funds and actively managed funds, are a basket of securities that trade on an exchange and can contain securities like stocks, bonds and commodities.
Investment funds like ETFs are considered a lower-risk investment because of the increased diversification over single-stock investing, by holding multiple stocks or other securities. Some also offer full transparency by publishing their holdings each day. This differs from traditional mutual funds that do not disclose their holdings daily, giving ETF investors more ability to see what is "under the hood."
Because an ETF is a marketable security it can be easily bought and sold on exchanges. And, unlike traditional mutual funds that trade once per day, ETFs trade freely throughout the trading day.
There are ETFs that target core sectors of the stock market, like health care and energy, while the largest tend to track the broadest indexes, like the stock market's S&P 500 or bond market's Bloomberg Barclays U.S. Aggregate Index. But ETFs are moving beyond their index fund roots, with niche sector funds, like robotics, genomic science, 3-D printing and cybersecurity, as well as leveraged and inverse ETFs, and active managers now launching their own versions of these popular investments.
They can be bought on margin and sold short. Investors can also manage risk by trading futures and options, mimicking the behavior of stocks. But they tend to lose some of their tax-advantages — a feature of ETFs that originally attracted many financial advisors and investors to them over traditional mutual funds — as they become more complex. Unless you're a seasoned professional, it is best to stick to ETFs that track a straightforward index.
Bottom line: ETFs are typically low cost, low risk when tracking a broad, core market index, and in the case of equity ETFs, mimic the trading behavior of stocks. It is no wonder they are so popular among both Wall Street and Main Street investors.