From 204 billion to 9.6 trillion: why ETFs became the favorite investment

Did you know that the ETF market size grew from $204 billion in 2003 to $9.6 trillion in 2022? This is no coincidence. Exchange-Traded Funds have revolutionized the way millions of investors access financial markets, combining the best of two worlds: the flexibility of trading like stocks and the security of diversification.

What are Exchange-Traded Funds?

An ETF is more than just an investment fund. It is a hybrid instrument that trades on the stock exchange throughout the market session, allowing buying or selling at real-time prices. Unlike traditional funds, which are valued only at market close, an ETF offers intraday liquidity from open to close.

The fundamental feature of these funds lies in their ability to replicate the behavior of stock indices, baskets of currencies, specific sectors, or commodities. For example, investing in SPY means gaining exposure to the 500 largest U.S. companies with a single transaction.

Main ETF categories

There are multiple variants designed for different investor profiles. Stock index ETFs replicate broad groups of companies, while sector ETFs focus on specific industries like technology or energy.

For those seeking currency exposure, there are currency ETFs that provide access to the forex market without complex operations. Commodity ETFs (like GLD for gold) derive their prices from futures contracts.

More aggressive options include leveraged ETFs, which amplify gains and losses through financial derivatives, designed for short-term strategies. On the other end, passive ETFs simply track an index without active management.

From the lab to Wall Street: how ETFs were born

The first index funds emerged in 1973 thanks to Wells Fargo and American National Bank. But the real turning point came in 1993 when the SPDR S&P 500 (known as SPY) started trading. This ETF became the most traded in the world and remains so.

From fewer than a dozen products in the 1990s, the industry grew exponentially: currently, more than 8,754 ETFs are listed globally. Approximately $4.5 trillion of the $9.6 trillion assets under management are in North America, demonstrating Western investors’ preference for these instruments.

Why investors choose them: key advantages

Extremely low costs: Expense ratios range from 0.03% to 0.2%, contrasting sharply with investment funds whose costs exceed 1%. Scientific studies show that this difference reduces a portfolio’s value by 25% to 30% over 30 years.

Enhanced tax efficiency: ETFs use an “in-kind” redemption mechanism that minimizes capital gains distributions. Instead of selling assets (generating taxes), the fund transfers physical assets to the investor, avoiding taxable events that occur with traditional funds.

Instant diversification: Buying an ETF is equivalent to purchasing multiple assets simultaneously. SPY provides exposure to 500 companies; GDX focuses on gold mining; IYR on real estate. Achieving this diversification by buying individual assets would be costly and tedious.

Transparency and intraday liquidity: Unlike mutual funds that close operations at the end of the day, ETFs trade throughout market hours at live prices. Portfolio compositions are published daily, allowing investors to know exactly what they own.

The machinery behind the scenes: how they work

ETFs are created through collaboration between fund managers and authorized market participants (generally large financial institutions). These participants continuously adjust the number of units outstanding so that the market price reflects the actual value of the underlying assets, known as Net Asset Value (NAV).

An arbitrage mechanism complements this: any investor observing a discrepancy between the ETF’s market price and its NAV can buy or sell to correct that difference. This automatic process ensures the ETF trades close to its true value.

The tracking error is a critical indicator here. It represents the difference between the ETF’s return and that of the index it replicates. A low tracking error (close to 0%) indicates the fund faithfully meets its objective. For example, SPY maintains an exceptionally low tracking error.

ETF versus its competitors

Compared to individual stocks, ETFs offer systematically lower risk thanks to diversification. While a single stock exposes the investor to company-specific risk, an ETF spreads that risk across multiple issuers.

Compared to Contracts for Difference (CFD), ETFs are passive investment products designed for long-term holding, whereas CFDs allow leverage and are short-term speculative tools with amplified risks.

Compared to traditional mutual funds, ETFs offer intraday trading, lower costs, and greater transparency. Mutual funds, on the other hand, are valued only at the end of the day and allow active management but with higher fees.

Limitations you should not ignore

Despite their advantages, challenges exist. Leveraged ETFs, while promising high returns, also amplify losses and are not suitable for long-term investors.

Certain specialized or small-scale ETFs may face liquidity issues, increasing transaction costs. Also, although passive management typically reduces costs, specialized ETFs can incur higher expense ratios than broad ETFs.

Dividends paid by some ETFs are subject to taxation, and the tracking error in some niche funds can be more significant, making exact index replication more difficult.

Smart selection strategies

When choosing an ETF, first examine the expense ratio: the lower, the better for long-term. Second, check liquidity by observing daily trading volume and bid-ask spread; high liquidity allows entering and exiting easily.

Third, analyze the tracking error: a low error indicates the ETF closely follows its index. Fourth, consider the portfolio composition published daily to align with your objectives.

Advanced strategies include using multi-factor ETFs that combine size, value, and volatility for uncertain environments; hedging ETFs to protect against specific risks; or Bear/Bull ETFs to speculate on market directions.

Conclusion: an indispensable tool

Exchange-Traded Funds have established themselves as key strategic instruments in modern portfolios. Their growth from $204 billion to $9.6 trillion in two decades reflects a reality: they offer accessible diversification, minimal costs, and unprecedented transparency.

However, remember that diversification mitigates certain risks but does not eliminate them entirely. Careful selection based on expense ratios, liquidity, and tracking error is essential. ETFs are not substitutes for comprehensive risk management but valuable complements in a deliberate and well-founded investment strategy.