The First ETF Was Launched 30 Years Ago, Revolutionizing Investing

The launch of the first exchange-traded fund (ETF) 30 years ago ushered in a new era of investing. Now, the ETF industry is bringing exotic trading strategies to the masses. ETFs offer investors a convenient way to access a wide variety of asset classes and investment strategies. And with the growing popularity of ETFs, more and more investors are able to take advantage of these unique investment vehicles.

The SPDR S&P 500 ETF Trust, which tracks the benchmark U.S. stock index, allows investors to buy and sell hundreds of stocks through a single, publicly traded share. This is the first time this has been possible.

The SPDR ETF and the funds that followed popularized the idea of simply following the market, a strategy known as passive investing. This approach has become increasingly popular in recent years as investors seek to minimize costs and maximize returns.

There are now ETFs tracking dozens of different asset classes, sectors and investing themes. These funds are favored for their low fees and advantageous tax structure compared with traditional mutual funds. Their popularity continues to grow, even in the midst of a bear market.

When the SPDR fund launched on January 22, 1993, few people could have predicted its impact.

"At the time, it was not a watershed moment, but it's now hard to imagine investing without ETFs," said Todd Rosenbluth, an industry veteran and head of research at VettaFi. "A whole generation of investors only thinks about using ETFs to get diversified exposure. They've opened up markets that previously were harder to obtain access to."

The industry is quickly expanding to include active management and more exotic investing products like leveraged and inverse funds. Proponents say the suite of cheap investing options has helped democratize investing. Others, noting the fast growth of risky ETFs that use leverage to amplify both returns and losses, are sounding the alarm about the potential fallout for inexperienced investors.

For years, ETFs have been gaining ground on mutual funds, which have traditionally been the broad-based investment option of choice for 401(k) retirement plans. However, this trend accelerated in 2022. U.S. ETFs took in almost $600 billion on a net basis in 2022, second only to 2021's record inflow, according to data from Morningstar Direct. This means that investors pulled nearly $1 trillion from mutual funds. This marks the largest gap in flows between the two types of funds on record.

Although ETFs are not likely to overtake mutual funds anytime soon, they are still a significant force in the investment world. ETFs had $6.5 trillion in assets at the end of 2022, compared to $16.3 trillion for mutual funds. The SPDR ETF, best known by its ticker symbol SPY, is the largest ETF, with approximately $370 billion in assets.

ETFs have several advantages over index-tracking mutual funds. ETFs can be bought and sold throughout the trading day, while mutual funds only price once daily at market close. ETFs also tend to have lower fees and expenses than mutual funds.

Index equity ETFs have significantly lower fees than equity mutual funds. The average expense ratio for index equity ETFs was 0.16% in 2021, or $16 annually per $10,000 of investment funds, compared with 0.47% for equity mutual funds, according to the Investment Company Institute.

Bartolini said that last year's market selloff likely served as a reminder for investors to reassess their portfolios, leading to further adoption of ETFs. Bartolini is the head of SPDR research at State Street Global Advisors, the asset manager behind SPY.

"When you have active managers who are underperforming and charging high fees, and you're getting hit with a capital-gains tax, that's going to lead people to leave," Mr. Bartolini said.

The downturn gave savvy investors an opportunity for tax-loss harvesting—selling funds to realize a loss and writing it off for tax purposes. A popular tax-loss harvesting strategy is to sell a mutual fund and quickly purchase an ETF with similar holdings. That practice, known as a wrapper swap, allows investors to realize a loss for tax purposes while staying invested.

The growth of ETFs is being driven by the emergence of active strategies and other new products. Passive strategies still made up 95% of the ETF market in 2022, according to Morningstar. But of the 431 new ETFs launched, more than half were active strategies, according to Mr. Rosenbluth. Active funds took in 15% of total ETF flows last year, nearing $100 billion, a record for active strategies.

Active ETFs have become increasingly popular in recent years, with many investors looking to get exposure to specific sectors or companies. One popular active ETF is Cathie Wood‘s ARK Innovation, which invests in “disruptive” companies, primarily unprofitable firms in the tech sector. However, the fund has come under pressure recently, with shares falling 67% in 2022.

Despite poor performance, investors continued to pour money into ARK. Individual investors showed similar interest in other speculative ETF offerings, including leveraged funds, raising concern over whether the industry is making it too easy for people to make risky bets.

The Direxion Daily TSLA Bear 1x Shares ETF, for example, aims to provide the inverse of Tesla Inc. shares' performance. According to Mr. Bartolini of State Street, it is the first ETF based around a single stock and allows widespread access to the kind of trade that once was reserved for institutional or high-net-worth investors with access to Wall Street dealers.

Elisabeth Kashner, director of global funds research at FactSet, has warned that investors who use leveraged funds need to be fully aware of the risks involved. She urged caution, saying that these products can be very risky if not used correctly.