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The first European ETF was launched in 2000, and since then the European ETF market has experienced tremendous growth. At the end of March 2019, assets under management in the European sector amounted to €760 billion, compared to €100 billion at the end of 2008. The market share of ETFs has increased significantly in recent years. At the end of March 2019, ETFs accounted for 8.6% of total assets under management of investment funds in Europe, compared to 5.5% five years earlier.

The use of ETFs has also evolved over time, as regular observations of investment professionals' practices in Europe demonstrate. EDHEC surveys show an increasing adoption of ETFs over the years, particularly for traditional asset classes. While ETFs are now used across a broad range of asset classes, in 2019 they were most prevalent in equities and sectors, with 91% (compared to 45% in 2006) and 83% of respondents, respectively, reporting their use. This is likely related to the popularity of indexing in these asset classes, as well as the fact that equity and sector indices are based on highly liquid instruments, which facilitates the creation of ETFs on such underlying assets. The other asset classes for which a large proportion of investors report using exchange-traded funds (ETFs) are commodities and corporate bonds (68% for both, compared to 6% and 15% respectively in 2006), smart beta factor investing, and government bonds (66% for both, compared to 13% for government bonds in 2006). Investor satisfaction with ETFs is high, particularly for traditional asset classes. In 2019, we observed a 95% satisfaction rate for both equities and government bonds.

The role of ETFs in the asset allocation process

Over the years, the results of the EDHEC survey have consistently shown that ETFs were used as part of a truly passive investment approach, primarily for long-term buy-and-hold investments rather than tactical allocation. However, in the last three years, the two approaches have gradually converged, and in 2019, European investment professionals reported using ETFs more for tactical allocation than for long-term positions (53% and 51%, respectively).

ETFs, which originally tracked broad market indices, are now available across a wide range of asset classes and market sub-segments (sectors, styles, etc.). While broad market exposure was a primary focus for 73% of users in 2019, 52% of respondents indicated they use ETFs to gain exposure to specific sub-segments. The diversity of ETFs increases the opportunities for using them for tactical allocation. ETFs allow investors to easily increase or decrease their portfolio exposure to a particular style, sector, or factor at a lower cost. The more volatile the markets, the more attractive it becomes to use cost-effective instruments for tactical allocation, especially since cost is an important criterion for 88% of respondents when choosing an ETF provider.

Expectations for the future development of ETFs in Europe

Despite the currently high acceptance of ETFs and the already high maturity of this market, a significant percentage of investors (46%) plan to increase their use of ETFs in the future, according to responses to the 2019 EDHEC survey. Investors plan to increase their ETF allocation to replace active managers (71% of respondents in 2019), but also intend to replace other passive investment products with ETFs (42% of respondents in 2019). Cost reduction is the primary motivation for increased ETF use for 74% of investors. Investors are particularly interested in further development of ETF products in the areas of ethical/SRI and smart beta equity/factor indices. In 2018, ESG ETFs saw growth of 50%, reaching a volume of EUR 9.95 billion, with 36 new products launched, compared to just 15 in 2017. However, 31% of respondents in the 2019 EDHEC survey still want additional ETF products based on sustainable investments.

Investors are also calling for ETFs that track advanced forms of equity indices, namely those based on multi-factor and smart beta indices (30% and 28% of respondents, respectively), and 45% of respondents would like to see further developments in at least one category related to smart beta equity or factor indices (smart beta indices, single-factor indices, and multi-factor indices). Reflecting the desire to use exchange-traded funds for passive exposure to broad market indices, only 19% of respondents expressed interest in the future development of actively managed equity ETFs.

Exchange-traded funds (ETFs) are investment funds that, like stocks, are traded on a stock exchange throughout the day. This distinguishes them from traditional mutual funds, which are traded only once a day (based on their closing price). Most ETFs are designed to replicate the performance of market indices (such as the S&P 500) by holding the same securities in the same proportions as a given stock or bond index. The advantages of ETFs over mutual funds include lower costs, the ability to track the performance of the overall market rather than investing in individual stocks, and potentially better investment returns, as active fund managers tend to underperform the market. These advantages have led to an astonishing 2,650 percent increase in the number of ETFs worldwide between 2003 and 2020.

Which is the largest ETF?

Many ETF providers offer not just a single, individual ETF, but a range of different funds that track various indices and invest in different types of securities. For example, BlackRock is the largest ETF issuer in the United States, with a market share of 36.4 percent (as of February 2021). However, under its iShares brand, BlackRock manages almost half of the 15 largest individual ETFs in the US by assets under management. Other leading ETF providers include State Street and Vanguard, while the largest single ETF is the SPDR S&P 500 ETF, managed by State Street, whose assets reached approximately $325 billion in February 2021.

Size of the ETF industry

Assets under management (AUM) of global ETFs increased from US$417 billion in 2005 to over US$7.7 trillion in 2020. The regional distribution of ETF assets was heavily concentrated in North America, which accounted for approximately US$5.6 trillion of the total global volume. However, the Asia-Pacific region exhibited the highest regional growth rate for ETFs at that time, despite representing only a very small share of the overall global ETF market.

The first ETF was created in 1989 by Index Participation Shares and was an S&P 500 ETF traded on the NYSE American and the Philadelphia Stock Exchange. This product was only sold briefly because a lawsuit by the Chicago Mercantile Exchange successfully halted its distribution in the US.

In 1990, a similar product, Toronto Index Participation Shares, which tracked the TSE 35 and later the TSE 100 index, was traded on the Toronto Stock Exchange (TSE). The popularity of these products prompted the New York Stock Exchange (NYSE) to develop a product that complied with the regulations of the United States Securities and Exchange Commission.

Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developed the Standard & Poor's Depositary Receipts fund, which was launched in January 1993. Known as SPDR or "Spider," the fund became the world's largest ETF. In May 1995, State Street Global Advisors introduced the S&P 400 MidCap SPDR.

Barclays Global Investors entered the market in 1996 in partnership with MSCI and Funds Distributor Inc. with the World Equity Benchmark Shares (WEBS), which later became the iShares MSCI ETFs. WEBS offered products based on 17 MSCI country indices, managed by the fund's index provider, Morgan Stanley.

In 1998, State Street Global Advisors introduced "Sector Spiders," separate ETFs for each sector of the S&P 500 Index. Also in 1998, the SPDR "Dow Diamonds" ETF, which tracks the Dow Jones Industrial Average, was launched. In 1999, the influential SPDR "Cubes" ETF was introduced, aiming to replicate the price movement of the NASDAQ-100.

The iShares line was launched in early 2000. By 2005, it had a market share of 44% of ETF assets under management. Barclays Global Investors was sold to BlackRock in 2009.

In 2001, the Vanguard Group entered the market with the launch of the Vanguard Total Stock Market ETF, which includes all publicly traded stocks in the USA.

iShares launched its first bond fund in July 2002: the iShares IBoxx $ Invest Grade Corp ETF, which holds corporate bonds. The company also issued an ETF on inflation-indexed bonds.

In 2007, iShares launched an ETF holding high-yield, high-risk securities (junk bonds) and an ETF holding US municipal bonds. State Street Global Advisors and The Vanguard Group also issued bond ETFs for the first time that year.

In December 2005, Rydex (now Invesco) launched the first currency ETF, the Euro Currency Trust, which tracked the value of the euro. In 2007, Deutsche Bank's DB X-Trackers launched the EONIA Total Return Index ETF, which replicates the EONIA index. In 2008, the Sterling Money Market ETF and the US Dollar Money Market ETF were launched in London.

The first leveraged ETF, i.e., with leverage, was issued by ProShares in 2006.

In 2008, the SEC approved ETFs that use active management strategies. Bear Stearns subsequently launched the first actively managed ETF, the Current Yield ETF, which began trading on the NYSE on March 25, 2008.

In December 2014, assets managed by US ETFs reached US$2 trillion, and by November 2019, US$4 trillion. In Europe, €1 trillion was managed in ETFs in December 2019.

ETF units, like regular investment fund units, represent a proportionate ownership of a special fund that is managed separately from the assets of the issuing investment company.

The investment strategy of exchange-traded funds (ETFs) is generally passive; the fund management does not invest the fund's assets based on its own opinions, but rather replicates the performance of a predefined benchmark in the form of a financial index (see Index Investing). Actively managed ETFs are also available, but these have a very small market share. Furthermore, the distinction between actively managed ETFs and strategy indices is not always clear-cut.

The fund management can generate additional income, independent of the benchmark's performance, by lending the fund's securities to other capital market participants and thereby generating lending fees.

Exchange-traded funds (ETFs) can be traded on the stock exchange at any time, similar to stocks. ETFs differ from regular investment funds, which are also sometimes traded on the stock exchange, in the following ways:

Investors typically buy and sell ETFs only on the stock exchange; purchasing them directly from the issuing investment company is not possible.
The composition of the fund's assets is published daily.
While traditional investment funds only publish their net asset value (NAV) once a day, ETF issuers continuously calculate and publish an indicative net asset value (iNAV) throughout the trading day.
Creating new ETF shares and redeeming existing ones involves specific processes: creation and redemption, respectively.
The price of exchange-traded funds is determined by supply and demand on the stock exchange, but for arbitrage reasons, it usually closely matches the net asset value. To ensure market liquidity, exchange-traded funds are managed by market makers who continuously provide bid and ask prices.

In contrast, non-exchange-traded fund units can only be bought and sold through the fund management company. The fund management company sets a price only once a day.

Exchange-traded funds (ETFs) should be distinguished from the similarly named exchange-traded notes (ETNs) and exchange-traded commodities (ETCs). These are not shares in a special fund, but rather special types of debt securities similar to certificates.

Creation/Redemption Process

The issuance of new ETF units takes place via a process specific to this type of security, the so-called creation process. Similarly, ETF units are returned to the issuing investment company via the so-called redemption process.

In the creation process, ETF shares are created in blocks of typically 50,000. The Authorized Participant (AP) provides cash or a basket of securities equivalent to the value of the ETF shares to be created to the investment company. In return, the investment company delivers the shares, which the market maker can then sell to investors via the stock exchange.

A special feature is the option of delivering a basket of securities. In the simplest case, its composition corresponds to the strategy of the ETF in question. For example, in the case of an ETF designed to replicate the STOXX Europe 50 index, the market maker can deliver a portfolio of securities containing the stocks included in the index according to their index weights. This approach is called "creation in kind." If the new securities are paid for with cash, it is referred to as "cash creation.".

Conversely, an Authorized Participant can return ETF units to the issuing investment company, for example, if they have repurchased a corresponding number on the secondary market. Similar to the creation process, they receive cash or a basket of securities in return. This is referred to as "redemption in kind" and "cash redemption," analogous to the creation process.

Institutional investors wishing to buy or sell large volumes can also do so directly with the investment company over-the-counter via the creation or redemption process. If the investor delivers or receives a basket of securities during the purchase or sale, this can offer tax advantages.

Reproduction errors

The replication error of an ETF is the difference between the returns of the ETF and its benchmark index or asset. A non-zero replication error therefore means that the benchmark index is not being replicated as stated in the ETF prospectus. The replication error is calculated based on the current price of the ETF and its benchmark. It differs from the premium/discount, which represents the difference between the ETF's (only once-daily updated) net asset value and its market price. Replication errors are more significant when the ETF provider uses strategies other than full replication of the underlying index. Some of the most liquid exchange-traded equity funds typically exhibit better replication performance because the underlying index is also sufficiently liquid to allow for full replication. In contrast, some ETFs, such as... Commodity ETFs and their leveraged counterparts do not necessarily offer full replication, as the physical assets cannot be easily stored or used to build leveraged exposure, or the benchmark or index may be illiquid. Futures-based ETFs can also suffer from negative roll yields, as seen in the VIX futures market.

While replication errors are generally rare among the most popular ETFs, they have occurred during periods of market turmoil, such as in late 2008 and 2009, and during flash crashes, particularly among ETFs investing in foreign or emerging market equities, commodity indices based on futures contracts, and high-yield debt securities. In November 2008, during a period of market turmoil, some lightly traded ETFs frequently exhibited deviations of 5% or more, in a few cases exceeding 10%, although even for these niche ETFs, the average deviation was only slightly more than 1%. The trades with the largest deviations were typically made immediately after the market opened. According to Morgan Stanley, in 2009, ETFs missed their targets by an average of 1.25 percentage points, more than double the average deviation of 0.52 percentage points in 2008.

Liquidity risk

ETFs have a wide range of liquidity. The most popular ETFs are constantly traded, with tens of millions of shares changing hands daily, while others are traded only occasionally or even go several days without any trading at all. Many funds are not traded very frequently. The most actively traded exchange-traded funds are highly liquid, with high trading volumes and tight spreads, and their prices fluctuate throughout the day. This contrasts with mutual funds, where all buys or sells on a given day are executed at the same price at the end of the trading day.

New regulations designed to force ETFs to cope with systemic stresses were introduced after the 2010 Flash Crash, when the prices of ETFs and other stocks and options became volatile, with trading markets skyrocketing and bids falling to as low as one penny per share, which the Commodity Futures Trading Commission (CFTC) described in its investigation as one of the most turbulent periods in the history of financial markets.

These regulations proved insufficient to protect investors during the flash crash of August 24, 2015, “when the price of many ETFs appeared to detach itself from its underlying value.” As a result, ETFs came under even greater scrutiny from regulators and investors. Analysts at Morningstar, Inc. asserted in December 2015 that “ETFs are a ‘digital-age technology’ governed by Depression-era laws.”.

Risks of synthetic ETFs

Synthetic exchange-traded funds, which do not own securities but track indices using derivatives and swaps, have given rise to concerns due to the lack of transparency of the products and the increasing complexity, conflicts of interest and lack of compliance with regulations.

Counterparty risk

A synthetic ETF carries counterparty risk because the counterparty is contractually obligated to replicate the index's return. The transaction is executed with collateral provided by the swap counterparty. One potential risk is that the investment bank offering the ETF may deposit its own collateral, which could be of questionable quality. Furthermore, the investment bank could use its own trading department as the counterparty. These types of structures are not permitted under European regulations, specifically the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive 2009.

Counterparty risk also exists if the ETF engages in securities lending or total return swaps.

Impact on price stability

Purchases and sales of commodities by ETFs can significantly influence the price of these commodities.

Some market participants believe that the growing popularity of exchange-traded funds (ETFs) may have contributed to the rise in share prices in some emerging markets, and warn that the leverage embedded in ETFs could pose risks to financial stability if share prices were to fall for an extended period.

Some critics claim that exchange-traded funds can be used, and have been used, to manipulate market prices, for example in connection with short selling, which contributed to the bear market in the US from 2007-2009.

Investors in exchange-traded funds (ETFs) incur the following costs:

• Costs that are summarized in the total expense ratio (TER), such as management fees, index fees and other costs, e.g. for prospectuses.
• Fund transaction costs

These costs are deducted from the fund's assets, as is standard practice with investment funds. However, the usual fees for stock market trading (order commission, brokerage fees, settlement charges, bid-ask spread) are paid directly by the investor.

Annual management costs are typically less than 1%.

ETFs that follow a passive investment strategy may incur lower transaction costs, and the costs of active fund management are eliminated.

Since ETFs are not purchased through the investment company, the issuance fee that is often payable is eliminated.