Exchange Traded Funds: What are they and should I invest in one?

Since the earliest days of trading goods, humans have looked for ways to decrease risk by sharing a cut of the profits. For example, it wasn’t seen as wise to invest all your capital in a single ship. If it sank, you’d lose everything. So, you’d invest in several ships, hoping that at least a few of them would make it back.

To better facilitate this “insurance” against total failure, merchants came up with the ingenious idea of a joint-stock company. Not only did this allow risk to be spread among many investors, but it created a market for the shares themselves—an exchange. This also turned out to be a more efficient way to allocate capital to those ventures with the best chance of generating a return.

In the late 18th century, a Dutch businessman created a way for smaller investors to share ownership of many stocks at once. It was the precursor to the mutual fund. And within a hundred years this innovation was introduced to the United States. Today, mutual funds that track indexes like the S&P 500 offer long-term investors potential diversification among hundreds of company stocks at relatively low cost.

Then in the late 1980s a physicist named Nate Most developed an instrument that offered further diversity and liquidity. It came to be known as the Exchange Traded Fund. Most, who had a background as a submarine engineer for the U.S. Navy, had been developing new investing products for the American Stock Exchange. Having had experience with commodities trading, he wondered if a similar system could be used to trade stock funds.

“I started thinking about a warehouse receipt holding the shares in a fund, which could then be divided up in pieces,” he explained in an interview. “You could reassemble the pieces and get back the stocks, but otherwise only the pieces would trade.”

The idea worked. And today, according to the Wall Street Journal, more than $6.6 trillion in the U.S. is invested utilizing ETFs.

Among the potential advantages of ETFs are their ability to be traded throughout the day (mutual funds trade once a day) and real time transparency about each fund’s underlying holdings. They also tend to have low expense ratios. And they can have tax advantages over mutual funds.