The history of ETFs is one of the evolution of indexing and of market innovation

The best Exchange Traded Funds (ETFs) offer well diversified, tax-efficient portfolios with exceptionally low management fees. Investors large and small can use ETFs to build diversified portfolios across a range of indexes or industry groups.

At the beginning of 2015 the global ETF industry had set a new record of $2.79 trillion assets held in 5,580 ETFs, listed on 62 exchanges in 49 countries. As of June 2015, Canadian listed ETFs held $87.4 billion in assets. The top 3 ETF providers as of the second quarter 2015 are iShares, SPDR, and Vanguard.

But how did Exchange Traded Funds (ETFs) become so popular, and how did they come into the market?

The history of ETFs begins with the concept of indexing. Without indexing, ETFs would not exist. When you hear the word “index,” it’s referring to a sample of the market that represents a statistical measure of the market as a whole.

Investment professionals have used indexing for decades, but it wasn’t until famed investor, John Bogle created the first index mutual funds in 1975, that everyday investors had access to index-based investments.

Index mutual funds are a type of mutual fund where the portfolio matches or tracks the components of a market index, like the Standard & Poor’s 500 Index (S&P 500). Index fund managers will analyze and pick stocks trading on the S&P 500 that have performed well and fit into different industry groups like Consumer, Energy, Technology, and Financial.

Investors can then buy a single share of the index fund without having to buy separate stocks and pay separate transaction fees. This tracking of a market index is what lead to the inception of the ETF.

The first ETF traded in 1989. It was called the Index Participation Shares (IPS). The IPS was an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. Because this product was so new and misunderstood, a lawsuit was filed by the Chicago Mercantile Exchange to stop the sale of IPS in the U.S.

In 1990, ETFs were introduced in Canada. The fund was called Toronto Index Participation Shares, and started trading on the Toronto Stock Exchange (TSE). The shares, which tracked the TSE 35 index and later the TSE 100 index, became very popular. It was this popularity that was the catalyst for US based markets to allow index funds. By 1993, the United States Security and Exchange Commission allowed the sales of ETFs by U.S. exchanges.

It wasn’t until that last decade that ETFs caught the attention of the investment market. If it wasn’t for the popularity of index mutual funds and other index based investments, we might have missed the evolution of exchange traded funds.

How do ETFs work?

ETFs trade on stock exchanges, just like stocks. Prices are quoted in newspaper stock tables and online. You’ll have to pay brokerage commissions to buy and sell ETFs. However, ETFs’ low management fees still give them a cost advantage over most conventional mutual funds.

As well, shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital-gains bills generated by the yearly distributions most conventional mutual funds pay out to unitholders.

Investors can buy ETFs via stock exchanges on margin or sell them short.

Now that you know the history of ETFs, are you more apt to invest in them? Do you currently hold any ETFs in your portfolio? Share your experience with us in the comments.