Fun with ETFs

By | ADAEZE JAMILA LINDIWE | Arttie has assigned this fun essay about ETFs to me this morning at our daily editors meeting, he said “write a fun essay about ETFs.” I tried to hide in the corner, but he was barking at me, so here I am. The title I chose: Having Fun with ETFs the Little Basket that changed the Market. As always, a quick note before we dive in: this is educational writing, not personalized financial advice, and I’m not a licensed advisor. Please consider your own situation, or speak with a professional, before putting real money to work. Imagine walking into a grocery store and discovering that instead of buying flour, eggs, sugar, butter, and vanilla one at a time, you could buy a single sealed box that contained a perfectly proportioned cake, available at any hour, for a few pennies of markup. That, in spirit, is the exchange-traded fund. It takes a whole basket of stocks, bonds, or commodities, wraps it in a single ticker symbol, and lets you buy or sell it as easily as a share of Apple. It sounds almost too simple to be revolutionary, and yet in barely thirty years the ETF has reshaped how ordinary people invest, how professionals trade, and how the entire industry makes its money. It is also, quite honestly, one of the more fun inventions in modern finance, because it lets you build a portfolio that reflects your curiosity, whether you want to own the whole American stock market, a slice of Japanese robotics, or a pile of gold bars you never have to store in your basement. The story begins in the aftermath of a very bad day. In October 1987, the stock market fell more than twenty percent in a single session, and one of the lessons regulators and academics drew from the wreckage was that the market lacked an easy way to trade a diversified basket all at once. Several early attempts at solving the problem followed, including index participation products in the United States that ran into legal trouble, and a Canadian product called Toronto Index Participation Shares that launched in 1990 and is often credited as a true forerunner or the vanguard of new investing products for the retail investor.

The breakthrough in the American market came in January 1993, when State Street Global Advisors listed the SPDR S&P 500 ETF on the American Stock Exchange. Its ticker, SPY, is one of the most recognizable strings of letters in finance, and it remains one of the most heavily traded securities on earth. The people behind the idea, including Nathan Most and Steven Bloom, had built something that behaved like a stock but held a portfolio, and the market was curious but initially unhurried about it. The 1990s and early 2000s were the awkward adolescence of the asset class. Barclays Global Investors built a family of country-specific funds that let Americans buy a basket of, say, German or Malaysian stocks without opening a foreign brokerage account. Sector funds arrived in 1998, slicing the S&P 500 into pieces such as technology, energy, and utilities. The Nasdaq-100 tracker, known by its nickname the Qubes, launched in 1999 and instantly gave everyone a way to ride, or be flattened by, the dot-com wave. In 2000, Barclays rolled out its iShares brand, and in 2001 Vanguard, the company that had popularized index mutual funds, created an ETF share class attached to its existing funds, which proved to be a clever structural twist. The 2000s then brought the great widening of the category. Gold arrived in a fund wrapper in 2004, which transformed a metal that had once required vaults and insurance into something you could buy with a mouse click. Bond ETFs, currency funds, commodity funds, and the first leveraged and inverse products followed, and the ETF universe began to resemble a department store with an aisle for every possible taste. The 2010s were the decade of triumph and of drama. Fee wars broke out among the giants, with expense ratios on the most popular index funds collapsing from what once seemed normal to figures that now round to almost nothing. A few brokerages began offering commission-free ETF trading, which erased another layer of cost for the retail investor, which provided a catalyst for more public participation in the equities markets.

In 2019 a regulatory change from the Securities and Exchange Commission, known as the ETF rule, standardized how most funds operate and made it easier to launch new ones, including actively managed ETFs, where a human manager makes decisions instead of following an index. In the 2020s, assets in American ETFs climbed past the ten trillion dollar mark, many mutual fund companies began converting or duplicating their products in ETF form, and in January 2024 the SEC approved the first spot Bitcoin ETFs, bringing even cryptocurrency into the familiar wrapper. A concept that began as an experiment on one exchange had become a main artery of global capital. To understand why ETFs are so clever, it helps to peek at the plumbing, because the mechanism is where the magic lives. A traditional mutual fund is bought and sold at the end of each trading day at a single price, with the fund company itself handling every purchase and redemption. An ETF, by contrast, trades on an exchange all day, with a price that moves second by second. Behind the scenes, large institutions called authorized participants act as a kind of wholesale channel. When demand for an ETF pushes its price above the value of the underlying holdings, these firms can assemble the basket of securities, hand it to the fund company, and receive new ETF shares in return, which they then sell on the market. When the ETF trades below its underlying value, the process runs in reverse, with the firms handing back ETF shares and receiving the basket. This creation and redemption machinery acts like a gravitational pull, keeping the market price of the ETF close to the true value of its contents. It also explains a major tax perk, because these exchanges are typically done in kind, meaning securities change hands rather than cash, which lets the fund avoid selling holdings and distributing capital gains to shareholders. That is why a broad stock ETF in a taxable account often produces fewer unwelcome tax surprises than a comparable mutual fund, many find this to be a welcomed aspect of many ETF funds.

As an investing tool, the ETF is practically tailor-made for the patient. A single purchase of a total market fund gives you ownership in thousands of companies, which is diversification that would have required a small fortune and a team of clerks a generation ago. You can set up automatic contributions, reinvest dividends, and let compounding do its quiet work, all while paying a fraction of a percent per year. Many people build an entire retirement plan out of just three or four ETFs, one for United States stocks, one for international stocks, one for bonds, and perhaps one for real estate, and they rarely have to think about the result. There is something almost comically elegant about the fact that the most boring possible approach, owning the whole market at nearly zero cost and ignoring it, has beaten the majority of professional fund managers over long periods. As a trading vehicle, the ETF reveals its other personality. Because it trades all day on an exchange, you can use limit orders, stop orders, and short sales, and you can even trade options on the most popular funds. That makes ETFs wonderful instruments for expressing a view quickly. If you think energy stocks are about to rally, you don’t need to research thirty oil companies, you can buy an energy sector fund. If you want to hedge a stock portfolio against a rough patch, you can short a broad index fund or buy an inverse one. Day traders adore the most liquid ETFs because their spreads are razor thin and their prices are rarely distorted by a single company’s bad news. Swing traders use them to ride sector rotations, where money flows from technology to healthcare to financials as the economic mood shifts. The convenience is genuine, though it comes with a reminder that anything easy to trade is also easy to overtrade, and the ETF wrapper does nothing to repair a trader’s lack of an edge. This is the point where the fun needs a little supervision, because not all ETFs are built the same, and some of the exotic ones come with sharp edges and must be monitored more closely like closed end funds or stocks.

Leveraged ETFs promise two or three times the daily return of an index, but they reset every day, and that daily reset creates a mathematical drag that can quietly erode returns over longer holding periods, especially in choppy markets. An index that falls ten percent and then rises ten percent leaves you down one percent, and a leveraged version leaves you down more, and the gap widens the more the market zigzags. Inverse funds suffer from the same issue. Commodity funds that hold futures contracts rather than physical goods can lose money when the futures curve slopes upward, because rolling from an expiring contract into a pricier one steadily bleeds value, a quirk known as contango. Some futures-based funds are also structured as partnerships that issue a more complicated tax form at the end of the year. Even plain bond ETFs have shown a surprising personality. During the market panic of March 2020, some bond ETFs traded at noticeable discounts to the value of their holdings, because the ETF price reflected real-time selling while the underlying bonds were so illiquid that their quoted values lagged behind. The lesson is that an ETF is a wrapper, and the wrapper can never be more liquid or more stable than the things inside it, though in that case it was arguably the ETF price that was telling the truth first. So how do you choose the right ETF for a portfolio? The best place to begin is not with the fund at all but with yourself. What is the money for, when will you need it, and how would you feel if it dropped thirty percent next year? A twenty-five-year-old saving for retirement and a sixty-five-year-old drawing income have very different needs, and the same fund can be perfect for one and reckless for the other. Once you know the job you’re hiring the fund to do, look at what it actually holds, because names can be wildly misleading. A fund with the word “dividend” or “innovation” or “clean energy” in its title may hold a very different collection of companies than you’d guess, so it pays to peek at the top holdings, the weighting rules, and the index being tracked for success.