To celebrate the 30^th anniversary of the ETF, State Street Chairman and CEO Ron O’Hanley recently sat down with Jagdeep Singh Bachher, Chief Investment Officer at UC Investments, to discuss the past, present and future of ETFs as part of our ETF@30 video series with industry leaders. That conversation was revealing about the role ETFs are playing in investment portfolios.

As Bachher explained: “Simplicity is a key part of how we (at UC Investments) invest and today, ETFs offer us a simpler way to execute our investment strategies as and when we see opportunities around the world, whether it is seeking returns or, for that matter, managing risks that we want to incorporate in our portfolio.”

But UC Investments, a leading global asset owner with about US$150 billion under management, is not alone. What began as a vehicle for exposure to US equities in the 1990s is fast becoming the go-to investment wrapper at the center of institutional and retail investment portfolios. So, just how did ETFs become portfolio building blocks?

To understand how this transformation occurred, start with the benefits ETFs can deliver. A recent article from State Street Global Advisors, How to Use ETFs in a Portfolio, outlines a number of key benefits including:
 

1.  Diversification and flexibility
ETFs can provide broad or targeted exposure to a wide range of asset classes, such as equities, bonds, commodities and real estate, allowing investors to diversify their portfolios with just a few trades. ETFs also offer access to specialized investment strategies, such as low-volatility or socially responsible investing, which gives investors the ability to tailor their portfolios to their specific investment goals.
 

2.  Lower expense ratios
Because most ETFs are passively managed, they typically have lower management fees and operating expenses compared to mutual funds. Additionally, ETFs are easy to trade and can be bought or sold on an exchange just like a stock, making them a convenient option for investors who want to buy or sell positions quickly.
 

3.  Increased transparency
ETFs offer greater transparency compared to other investment options. ETFs disclose their holdings on a daily basis, allowing investors to see exactly what they are investing in, and how their investments are performing.

And that’s just the beginning, as ETFs offer additional benefits such as liquidity, tax efficiency (in certain jurisdictions) and reduced cash drag on performance.

But ETFs weren’t originally designed to be portfolio building blocks. They were designed with market stability in mind, following the October 1987 market crash. At the time, the SEC identified program selling of individual stocks as a factor behind the crash, and the American Stock Exchange devised the concept of a single trade of a basket of securities that could mitigate volatility. This ultimately led to the creation of the ETF.

At first, institutions leveraged these products as tactical trading tools – but something happened along the way. As ETF issuers expanded products across asset classes, sectors and geographies, advisors recognized they now had a cheaper, more liquid and tax-efficient investment vehicle that could be used to manage the asset allocation for client portfolios.

During these early years, ETFs were exclusively index-based or passive ETFs. Actively-managed ETFs have more recently further expanded advisor choice. Recall the first active fund was launched in 2008, but it wasn’t until the enactment of the Rule 6c-11 in 2019 that active ETFs exploded. In fact, as we point out in our recent article, The Unlimited Potential of Actively Managed ETFs, it took 11 years for active managers to launch 325 ETFs before the Rule 6c-11, and a little over three years to launch close to 750 more. One might argue that changing regulation was another catalyst for ETFs' expansion as portfolio building blocks.

Fast forward to today, and we’re seeing continued momentum in ETFs. A telling data point from a Cerulli report¹, US Exchange-Traded Funds Markets 2022, highlights strong interest in mutual fund to ETF conversions. The report states that half of all polled managers reported evaluating converting mutual funds to ETFs, a shift that could make a big difference given the approximately US$20 trillion mutual fund ecosystem. And in that same report, 97 percent of polled participants expected the ETF industry to gather either significant or moderate flows over the next 12 months.

Taking a step back, the reason behind ETFs’ popularity may lie in their versatility. In addition to allowing investors to broaden their asset allocation, ETFs can be used to meet strategic goals, allocate funds tactically, access hard-to-reach markets, and help with ongoing portfolio management. It’s no wonder that ETFs are increasingly being used as portfolio building blocks for both retail and institutional investors alike.