When the wizards on Wall Street create new financial products, the results are usually complex and risky fare that are incomprehensible and often unobtainable to retail investors. Swaps, derivatives and other products can be big money makers for hedge funds and trading desks, but these products are not intended for the so-called average investor. With that said, one of the more recent financial inventions has left an indelible impact on the market and created a world of opportunity for retail investors at the same times. We’re talking about the advent and the evolution of the exchange-traded fund (ETF).

The Beginnings

When and where the first ETF came to market is somewhat debatable. A variation of an exchange traded product was introduced in Canada in 1989 to track the largest stocks traded in Toronto, known as the Toronto Index Participation Fund, but most financial historians would point to the introduction of the SPDRs in 1993 as the true beginning of the ETF industry. SPDRs are ETFs that tracks the S&P 500 index.

Trading under the ticker SPY, SPDRs is still around today and is the largest ETF by assets traded on U.S. exchanges. In terms of product offerings, the ETF business got off to a relatively slow start. Asian markets didn’t begin featuring ETFs until 1999 and Europe didn’t arrive on the scene until 2001. By 2002, there were just 246 ETFs available around the world and nearly half of them traded on European exchanges.

Fast-forward a few years and you’ll see just how popular (and important) ETFs are. At the end of 2009, there were nearly 1,000 exchange traded products trading on U.S. exchanges. This number includes over 100 exchange-traded notes (ETNs), a product related to but different from ETFs. Most industry followers estimate the number of ETFs available to U.S. investors will reach 1,000 sometime in 2010.

A Real Threat to Mutual Funds

One statement that investors have heard over and over again about ETFs is that they’re mutual funds that trade like stocks with smaller management expense ratios. This may sound like an over-simplification, but the statement is essentially true. Think about why you buy a mutual fund. You buy a mutual fund to get exposure to a basket of many stocks or sectors because purchasing 15, 20 or more stocks individually doesn’t make sense on a cost basis and requires a lot of research.

Equity-based ETFs offer investors the same advantage, but with superior liquidity. Mutual funds trade at just one price over the course of a trading day and that is their net asset value. You can buy a mutual fund in the morning and your friend can buy the same one three hours later and you’ll both get the same price. On the other hand, ETFs issue shares to investors and these shares trade like shares of traditional stocks. That means ETFs can be useful tools for long-term investors and short-term traders alike.

But has the evolution of ETFs had a negative impact on mutual funds? To be sure, the size of the mutual fund industry dwarfs that of the ETF industry. At the end of 2009, U.S. mutual funds had over $18.7 trillion in assets under management. Assets under management for ETFs moved above $1 trillion for the first time at the end of 2009. That’s a big discrepancy, but consider that ETFs held only $534 billion in assets at the end of 2008 and it is clear that ETFs are more than just a thorn in the side of mutual fund companies. ETFs are legitimate competitor.

How are mutual fund firms responding? Well they’re getting into the ETF business themselves. Mutual fund issuers like John Hancock, Fidelity, Putnam and T. Rowe Price have all announced plans to get into the ETF business and PIMCO, the largest manager of fixed income assets in the U.S. has already made a big splash in the ETF arena.

More Advantages over Mutual Funds

The advantages ETFs hold over mutual funds don’t end with liquidity. In fact, that’s simply a starting point. There are two asset classes that are both well-represented by both ETFs and mutual funds: Bonds and U.S. stocks. You can pick and choose whether your investment style is better suited to ETFs or mutual funds when it comes to those asset classes, but know that if you want to branch out to explore various investment potentials, ETFs are the better bet.

Think about some of the asset classes that many investors don’t include in their portfolios for a variety of reason. Commodities, emerging markets and foreign currency come to mind. ETFs are easily the best avenue for conservative investors to access securities like gold, oil and currencies beyond the U.S. dollar. The traditional way of playing these markets is with futures. which requires a significant outlay of cash and a big risk increase to your profile.

On the other hand, you can purchase a gold or euro ETF and know that is going to trade like a stock; this position can be bought and sold at any time without any front-end load or back-end load fees. Mutual fund offerings in this arena are scant to say the least and usually enforce a higher fee structure.

We can’t forget about emerging markets. Take a look the best performing ETFs from 2009 and you’ll find that many of the top performers were securities based on the emerging markets. As the ETF industry evolves, more and more issuers are developing country-specific ETFs for countries that would otherwise be inaccessible to retail investors. Poland, Malaysia, Singapore and Vietnam are just a few of the exotic locales ETFs can give you access to and there will surely be more to follow. Good luck finding comparable mutual fund offerings which offer similar types of advantages.

Lower Costs

That brings us to our next point. Owning an ETF or mutual fund costs more than just your initial purchase price. There are fees and expenses associated with your investment. Since most mutual fund managers are trying to beat a benchmark index, they will trade in and out of stocks in an effort to accomplish their goal of beating the benchmark. They demand compensation for their efforts. Also, mutual fund issuers don’t want investors to redeem their shares, so there can be more fees when you sell your mutual fund.

By comparison, ETFs are most cost-efficient. Their expense ratios rarely traverse 1%. ETFs even feature lower expenses than many passively managed index funds. No one wants fees and expenses eating away at their profits and that’s just one more reason to consider ETFs.

ETFs also feature tax benefits that their mutual fund counterparts can’t match. When you sell a profitable position in an ETF, you simply pay capital gains taxes. Mutual funds also expose you to capital gains, but there is a hidden tax issue with mutual funds many investors don’t know about. Mutual funds accumulate gains for winning positions that turn into tax liabilities. Guess who bears the burden for that tax liability. The investor.

Conclusion: What Does the Future Hold for ETFs?

This much is certain: ETFs aren’t going anywhere and calling them the most important addition to the retail investors’ arsenal in the past several decades may be an understatement. It is likely that more investment firms will enter the ETF fray and that the product offerings will range from the benign to the exotic. Specialty ETFs that give investors double and triple leverage, while controversial, have proven popular, as have ETFs that attempt to replicate hedge fund strategies. Investors can expect more of those ETFs coming to market in the years ahead.