Question: What is the history behind the mutual fund and the ETF?

--Mike M., Minneapolis

Answer: If you ask the average person to name a life-changing invention, you'll probably hear answers such as, 'the cotton gin,' 'the telephone,' 'the automobile' or 'the light bulb.' That's no surprise -- those inventions have changed the course of history and how we live our everyday lives.

But famous inventions don't have to be mechanical or pharmaceutical to have profound impacts on how we live our lives. For example, few people will answer 'health insurance' or 'life insurance,' even though those inventions have drastically reduced the prospect of financial destitution due to illness or a death in the family.

Mutual funds and ETFs are particularly due credit as important financial inventions. They have significantly helped average people improve their standards of living by being able to diversify their holdings, get professional management and invest in ways that were formerly only available to the very wealthy. In turn, mutual funds and ETFs have created and preserved considerable prosperity for millions of people, though few know much about their history.

Mutual Fund History In A Nutshell

A mutual fund is a pool of money from everyday investors like you. The driving idea behind them is that there is power in numbers. That is, by pooling their resources, investors can hire a fund manager who will use their money to buy and sell securities on their behalf and lower their risk by spreading those investments across different industries or countries.

The sources vary, but most agree that the first mutual funds surfaced in Europe in the early 1800s. They eventually made their way to the United States just before the Great Depression, and when the market famously crashed in 1929 and the Securities and Exchange Commission passed the Securities Act of 1934 and the Investment Act of 1940, mutual funds became subject to many of the regulations that apply today.

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Regardless of the new restrictions, the mutual fund industry grew as investors became more educated about diversification, though by the 1950s only a few dozen existed. They became wildly popular in the 1980s and 1990s, though, when bull markets were generating huge returns for mutual funds. The popularity was fueled by the rock-star status that some fund managers gained, and by the early 1990s, about 4,000 mutual funds were operating. They were pooling trillions of dollars from investors, and fund managers were using the money to make investments that opened up entire markets and economies around the world.

Mutual funds proliferated but also began to specialize. At first there were simply a few funds that invested 'in stocks' or 'in bonds.' By the late 1990s, there were funds that invested only in emerging markets or high-growth stocks or junk bonds or socially responsible companies, for example. Today, mutual funds are staples of 401(k) and pension investments, but as one of the largest, most popular investment vehicles ever created, plenty of other investors are using them as well.

The Rise Of The ETF

For a long time, mutual funds had a near monopoly in retail investing -- and they are still the most popular and common means of participating in the stock market and diversifying a portfolio. But the industry evolved in a major way when Standards and Poor’s introduced the S&P Deposit Receipt (SPDR, or “Spider”) in 1993. Purchasing Spiders gave investors a way to track the S&P 500 without having to purchase shares of a mutual fund.

Exchange-traded funds (ETFs) are essentially passive mutual funds that usually track an index and allow investors to purchase a basket of securities in a single transaction. ETF shares are basically legal claims to underlying shares held in a trust by the fund’s creator or authorized participant, which is usually a market maker, specialist or institutional investor. These underlying shares are grouped into creation units, and the ETF shares are fractions of these creation units.

ETFs quickly grew for a few reasons, not the least of which was new academic research showing that passive investing -- that is, infrequent buying and selling -- generates the same if not better returns than active investing. This was a blow to mutual funds, which were (and to a large degree, still are) all about active investing in the pursuit of above-average returns.

Also, professional mutual fund managers aren't cheap -- they have stressful jobs and must get years of highly technical education to do their jobs. To pay for this, mutual fund investors pay a percentage of their assets in fees every year. But if the research was showing that mutual fund managers weren't really bringing higher returns, was it worth paying them so much? The ETF companies said no, which made it possible for them to charge fees that are much lower than those of mutual funds and in turn allow investors to keep more of their own money.

These characteristics, combined with lower minimum investment requirements, certain tax advantages, and the ability to buy and sell ETF shares during the day (as opposed to mutual fund shares, which trade only once a day) helped the ETF industry blossom into a multi-trillion-dollar industry that rivals the mutual fund industry in size. This was especially the case during and after the 2008 financial crisis, which heightened investors' sensitivity to the trading-liquidity limitations of mutual funds.

Bottom Line

The financial markets get very little credit for their inventions, even though those inventions have helped people live better, have helped grow economies, and have helped people in emerging markets develop and prosper. Necessity is the mother of invention, as the saying goes, and as the needs of investors evolve, so too will financial products.