How ETFs Became the Market

If you work in exchange-traded funds, memories of 2008 aren’t all doom and gloom.

Lehman Brothers’ collapse in September of that year ushered in a new era for ETFs. And they've been on a roll ever since. Assets in the low-cost portfolios that trade like stocks and typically track an index have swelled to $5 trillion globally, up from less than $700 billion before the financial crisis. Meanwhile, the number of funds has more than doubled as they gradually account for bigger and bigger pieces of the equity, bond and commodity markets.

Although they started trading in the U.S. in 1993, the financial crisis marked a turning point for ETFs. Banks were forced to shed large inventories to bolster their balance sheets. And retail investors who’d lost their shirts went looking for ways to diversify their risk. ETFs offered both a solution.

By packaging slices of the market into tradeable vehicles, ETFs became the go-to instrument for professionals seeking instant, liquid exposure to markets around the world. Mom-and-pop savers, meanwhile, got a cheap, transparent way to buy companies for the long haul.

But in remaking financial markets in their image, ETFs have fueled a fear that indexed investing will trigger the next crisis. Evidence for that is patchy, but the allegations—that ETFs sever securities from their fundamentals, that they encourage volatility, that they erode market efficiency to the point of Marxism—feed a debate that ETF lovers and phobics alike have to embrace.

With the push of a button, traders at banks or the high-frequency firms that have largely taken their place driving markets can bet on news in the U.S., as well as issues affecting nations around the world. Think political crises in Brazil or economic sanctions on Turkey. ETFs proved useful when Greece’s local market shut down during the sovereign debt crisis, giving investors an outlet to trade. At times like these, ETFs step up and can absorb more volume than the local market itself.

To satisfy these sophisticates, issuers have added new products miles removed from the humble S&P 500 Index. Want a leveraged bet on volatility? Or an inverse geared wager on the death of the mall? Anyone with a brokerage account can now play alongside the professionals. Both also have their pick of a swath of so-called smart-beta strategies tracking indexes that shun traditional market-capitalization weightings. These products promise targeted access to momentum stocks or undervalued companies.

But even as ETFs grow more sophisticated in terms of products, users and uses, ordinary investors still account for more than half of the assets. The reality is that if your grandma owns an emerging-markets ETF, she’s sitting alongside the likes of Bridgewater Associates and a Singaporean sovereign wealth fund. Issuers are committed to making sure that retail money sticks around, cutting fees on ETFs to as low as 30 cents for every $1,000 invested.

Different investment profiles and horizons arguably make funds more stable, but protecting the little guy is something U.S. regulators are thinking about as ETFs top $3.7 trillion in assets. For issuers now looking to expand globally, it’s one risk they’ll need to address to successfully spread around the world.