Happy birthday to the SPDR® S&P 500® ETF Trust (SPY), which started trading 31 years ago today (1/21/93). It’s the original Exchange Traded Fund or “ETF” and is a single stock that tracks all 500 stocks in the S&P 500.

What are ETFs?

ETFs are baskets of stocks that trade as a single stock. They are similar to mutual funds, but the mechanics of how they work are different: they trade throughout the day vs. after the market closes, and they are more tax efficient because they have lower (usually zero) capital gain distributions to shareholders than mutual funds.

Most ETFs track an index — such as ones that track major parts of the global stock market, like the S&P 500 (US large caps), Russell 2000 (US small caps), and MSCI EAFE (developed international). But there are thousands of other indices, including those that cover industries (like technology, financials, pharmaceuticals) or different ways to weigh companies (by dividends, value, growth, volatility). In fact, there are more indexes (5,000 +) than there are U.S. publicly traded stocks (3,700).

In addition to ETFs that track indexes, there’s a growing trend of ETFs that are actively managed — there are now over $400 Billion in actively managed ETFs..

The Explosion of ETFs

While ETFs were novelties in the early to mid-1990s, that single ETF spawned an entire industry that has exploded in size. Here’s a chart of the number of ETFs since 2003:

And here’s how the amount of assets in ETFs has ballooned in the past two decades (note that the drop in 2022 was due to the market declining — there were over $600 Billion of net inflows into ETFs that year):

Investment Industry Entropy

Is having all these ETFs good for investors? Maybe. I wrote about this in the last chapter of my book where I discuss the siren song of investment complexity:

In physics, entropy refers to a closed system’s general progression from order to disorder. It’s one of the universe’s fundamental laws and is summarized as “things fall apart.” Or, “rust never sleeps.” For example, when thrown to the wind, an ordered deck of cards scatters in a disordered fashion, while an unordered deck thrown to the wind does not reorder itself. Also, when you drop an egg, it breaks; a broken egg won’t pull itself back together (vide Humpty Dumpty) no matter how hard you try or how long you wait. Entropy gives time its arrow; the past flows into the future, not vice versa.

The financial system has its own version of entropy: it progresses from simplicity to complexity. Over the past fifty years, we’ve seen the rise of mutual funds, ETFs, hedge funds and the alternatives industry, derivatives, structured products, collateralized loan obligations, credit default swaps, the securitization of debt instruments, liquid alternative funds, and so on. Have these innovations and the accompanying rise in complexity been beneficial to investors? The answer, on the whole, appears to be no. Greater size and complexity generate fees and taxes that eat into returns and make practicing good investment behavior more challenging. Vanguard founder John Bogle put it this way: “Financial institutions operate by a kind of reverse Occam’s razor. They have a large incentive to favor the complex and costly over the simple and cheap, quite the opposite of what most investors need and ought to want.”

Even when a financial innovation initially offers greater simplicity, it evolves toward greater complexity. For example, the index mutual fund industry, which offered a simple way to gain low-cost, diversified equity exposure, gave rise to single stocks that track indexes in the form of ETFs. That seems straightforward and nice. But what began as a single ETF that tracked the S&P 500 has since spawned over 7,600 ETF products. Looking to expand the investable universe of ETFs, the investment industry has created more indexes than stocks (5,000 US indexes versus about 4,000 US public companies).

Access to thousands of ETFs tracking thousands of indexes provides an easy mechanism for investors to focus on specific industries or trends that interest them. For instance, if you want to invest in companies related to electric vehicles, you can buy an ETF that tracks an electric vehicle index. But should you really buy ETFs that focus on specific themes or sectors? Do you know something other investors (including the pros) don’t know about EV stocks? As we learned in Chapter 7, investing in trends is challenging.