The Fortunes & Foibles of Exchange-Traded Funds

William Birdthistle, Chicago-Kent College of Law

Abstract

One of the most dynamic and complex new investment vehicles on the market today is the exchange-traded fund, a security that provides the diversification of a mutual fund but trades on an exchange like a stock. In just over a decade, the number of ETFs has proliferated to well over 500, attracting almost half a trillion dollars in investment. Most of that growth has occurred in just the past two years, and ETFs 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 ever-greater prominence, for good or for ill, in the coming years. By exploring the structure, advantages, and shortcomings of ETFs, this Article explains the implications of the dramatic growth of ETFs. Using a novel pricing mechanism that harnesses the utility of arbitrage, ETFs provide investors with accuracy, efficiency, tax advantages, and a range of investment choices, while insulating investors from the structural problems with mutual funds. Yet critics decry their brokerage fees and their vulnerability to harmful short-term trading. This article argues that the mutual fund industry and its recent spate of dramatic scandals contributed to the growth of ETFs and concludes that mutual funds offer vivid warnings of the conflicts of interest that may come to afflict the ETF industry as it continues to grow.