2008 • Volume 33 • Number 1

The Fortunes and Foibles of Exchange-Traded Funds: a Positive Market Response to the Problems of Mutual Funds

William A. Birdthistle

One of the most dynamic and complex new investment vehicles on the market today is the exchange-traded fund (ETF), a security that provides the diversification of a mutual fund but trades on a securities exchange like a stock. In just fifteen years, the number of ETFs has proliferated to well over 600, attracting more than half a trillion dollars in investment. The majority of that expansion has occurred in just the past two years, largely as a consequence of recent difficulties in the mutual fund industry. With ETF sponsors aggressively seeking to create novel kinds of ETFs and to add ETFs to retirement account menus, these funds are projected to continue growing at a pace far faster than hedge funds and mutual funds in the coming years.

Yet, for all this extraordinary growth, legal scholars have virtually ignored ETFs. This article seeks to establish a descriptive and conceptual framework for the scholarly discussion of these funds as they gain evergreater prominence, for good or for ill, in the coming years. In exploring the structure, advantages, and shortcomings of ETFs, this article argues that ETFs are a positive market response to the shortcomings of mutual funds.

ETFs use a novel pricing mechanism that harnesses the utility of arbitrage to provide investors with accuracy, efficiency, tax advantages, and a range of investment choices, while insulating investors from many of the structural problems associated with mutual funds. Despite these advantages, critics decry their brokerage fees and vulnerability to harmful shortterm trading. This article argues that the mutual fund industry and its recent spate of dramatic scandals contributed to the emergence of ETFs and concludes that mutualfunds offer vivid warnings of the conflicts of interest that may come to afflict the ETF industry as it continues to grow.