Exchange-Traded Funds

Exchange-traded funds were invented for small investors. Like index funds, which they resembled, ETFs weren’t meant to produce world-beating returns but to mirror the performance of a broad group of securities — the original ETF, State Street’s SPDR, launched in 1993, tracked the S&P 500. Funds like that were a simple way for small investors to reduce risk by diversifying portfolios. ETFs also have lower fees than mutual funds, lower taxes than index funds, and are easier to buy or sell quickly than either. Those advantages have lifted ETF-managed assets to more than $3.3 trillion in the U.S. But along the way they got less simple. These days ETFs come in thousands of flavors and are popular with hedge funds and institutional investors as well as moms and pops. An increasing number track less-traded markets such as junk debt, use derivatives or heavy borrowing to enhance returns, or laser-in on niche segments of the investable universe. That has regulators wondering whether the more exotic versions need to be reined in lest they damage investors and markets alike.

U.S. ETFs have absorbed more than $450 billion this year with almost a third going into ETFs that buy corporate bonds, government debt or loans. These products have ballooned to $583 billion, up from $311 billion at the end of 2014, and from $144 billion at the end of 2010. Regulators are concerned that during a market drop such ETFs may exacerbate a sell-off, since many are made up of high-yield securities that change hands infrequently. ETF providers have responded by slicing and dicing the market into increasingly specific chunks, with some products weighted toward credit quality and others toward value or stability, for example. Raising the stakes, some providers have transformed these historically passive funds into active products, with managers trading the underlying securities during the day to try to beat an industry benchmark. These ETFs currently make up about 1 percent of ETFs but a new structure could accelerate their growth: Exchange-traded managed funds — or ETMFs in industry parlance — don't need to disclose their holdings every day, as required of their passive cousins. That could spur mutual-fund managers leery of the sector’s traditional transparency to expand into ETFs. Newcomers certainly need an edge; Blackrock and Vanguard together control more than 65 percent of the market, and their share is only getting bigger. Even some established issuers are feeling the heat, encouraging the growth of ETFs in less crowded markets such as Europe and Asia.