Published: April 2025
This paper is intended for those without a strong finance background to understand the benefits of passive investing and major milestones in its development. This is not a technical paper in any way, but should be helpful in understanding why investors choose passive products. In the following sections, we show why basket products like mutual funds and ETPs are significant unlocks in liquidity of underlyings, why each development in passive investing has proved significant, and where we envision the space will move.
Financial Market Fundamentals
Equities, futures, and debt instruments are among the oldest financial tools, forming the backbone of modern markets. Equities (a share of ownership of a company) date back to the 1602 IPO of the Dutch East India Company; debt (interest paying) instruments like loans and bonds have existed since ancient Mesopotamia; and futures (agreements for delayed purchase at given prices) trace to 17th-century Japan. These instruments underpin today’s global financial system, enabling capital formation and risk management at massive scale.
Nonetheless, these products have long been known to be unsuitable for the majority of investors. Successfully picking individual equities, for instance, requires ample understanding of company fundamentals and exposes investors to idiosyncratic risks. Within five years of the listing of the Dutch East India Company, Shakespeare wrote his cautionary tale—The Merchant of Venice—about the dangers of concentrating wealth in specific companies (the conflict of the story arises from a failed investment in merchant ventures, similar to investing in the Dutch East India Company). Evaluating the trustworthiness of debtors and performance of futures proves no easier, with even the most sophisticated investors regularly failing to outperform markets. (Kosowski et al.; Griffin et al.)
Mutual Funds
Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.
— Warren Buffett
Even those with access to capital often avoided financial markets due to their inherent risks. Recognizing an untapped market, asset managers realized that they could earn massive fees by offering diversification-as-a-service. As a result, the first mutual funds were issued in Amsterdam in the 1770s. These investment vehicles offered huge advantages over individual security picking. They allowed small investors to pool their wealth which enabled managers to scale their efforts to conduct market research, build and rebalance portfolios, and develop new strategies.
Individual investors benefited from growing market segments, not needing to decide on individual equities, bonds, or futures. They simply specify their objectives—growth, income, exposure to healthcare, etc.—and fund managers are happy to identify or create a product, allowing each to profit in ways neither could before.
These early forms of mutual funds came with a notable downside, namely that shares were not easily tendered for cash when investors wanted to pull their money, resulting in significant fees for those who needed liquidity. The first “open-end” mutual fund—one able to be redeemed for cash or underlying shares—was created in the United States in 1924. Once per day, investors could trade their shares at net asset value (NAV), unlocking huge efficiency gains and investor interest compared to close-end counterparts (Lee, Schleifer, and Thaler).
Open-end mutual funds allowed for vastly larger shares of the population to achieve easy diversification even before a clear regulatory framework was developed. The Great Depression resulted in the creation of the SEC and the Investment Company Act of 1940 which defined how these funds could trade. Over the following forty years, with a burgeoning middle class saving for retirement in indices such as the Dow Jones Industrial Average, the mutual fund market ballooned from hundreds of millions of dollars to hundreds of billions by the 1980s. The market for passive investing had ample room to grow.
Exchange-Traded Products
Mutual funds were a booming business, but they were fairly limited in their use cases, mainly for long-term buy-and-hold strategies such as retirement funds, as they are frequently used today. In the 1990s, a far better alternative was developed that allowed passive investing to grow to the multi-trillion dollar industry it is today: exchange-traded products (ETPs).
Building on the success of the mutual fund industry, savvy managers at State Street developed the first such fund: the SPDR S&P 500 ETF Trust with the ticker SPY. This fund revolutionized passive investing, giving access to the broad performance of US markets with the addition of high liquidity and cheap fees. SPY’s success has led to ETP investing to reach the heights of tens of trillions of dollars in trading. To understand the reason for this explosion in assets under management, we need to understand the differences between mutual funds and ETFs which is described below.
| ETPs | Mutual Funds | Similarity or Difference | |
| What are they? | “Baskets of goods” | “Baskets of goods” | Similarity |
| How are they managed? | Active or Passive | Active or Passive | Similarity |
| Minimum investment? | Price of one share, must purchase discrete shares thereafter | Usually a minimum investment, but can invest any amount beyond that value | Difference |
| Frequency of trading? | Any frequency during exchange hours | Once per day | Difference |
| Location of trading? | On-exchange | Through brokerage | Difference |
| Management fees? | (Usually) lower | (Usually) higher | Difference |
| Other costs? | Exchange fees, regulatory body fees, bid-ask spread, capital gains | Sales/redemption fees, purchasing fees, capital gains | Difference |
| Shortable? | Yes | No | Difference |
There are more exhaustive discussions of the differences between these two types of products, but to understand the benefits (and eventual points of improvement) related to ETPs, we can winnow down to a few very specific aspects of their differences.
Exchange Trading
By trading on exchange, ETPs are able to have continuous liquidity throughout market hours. As long as a market maker is willing to buy or sell the fund, investors can enter or exit positions at will. For retail investors, this creates a much lower hurdle to enter passive markets, as brokerages like Robinhood do not offer mutual fund investments and high minimum costs on other brokerages provide frictions to invest. For institutional investors, near-constant liquidity allows for instantaneous responses to news, model changes, and rebalancing needs. Pensions and hedge funds alike invest in ETPs, not mutual funds. Access is an important reason for the growth of passive investing, but it is only half the picture.
Costs
As stated above, ETPs usually charge lower management fees for many reasons, but the primary one is a feature known as the Creation/Redemption mechanism. We will discuss this topic in another piece in the future, but for now we will provide a brief explanation here. When an investor enters a position in a mutual fund, the managers take the investor money and use it to buy shares of the underlying fund. Since trading must be conducted at NAV in a mutual fund, the time available for a mutual fund to conduct such a purchase is limited, explaining why trading can only occur once per day (NAV values are only calculated once per day, with exact measurement dependent on fund prospectuses). These trades include all of the underlying costs that investors must pay when purchasing an ETP, which are then passed on to end users. For ETPs however, market makers provide liquidity continuously. If there is sufficient investor demand to increase the number of shares outstanding of an ETP (a creation), then the market maker will conduct all underlying transactions to seed more shares. Market makers frequently can conduct these trades at significantly lower costs than mutual funds can, saving end investors money. Other times, when flows negate each other or relatively low, they obviate the need to conduct a creation/redemption in general.
Nonetheless, mutual funds announce their specific fees in their prospectuses, which allow investors to have a deterministic view of costs. Conversely, because ETPs trade on exchange, investors are exposed to fees in the form of variable bid/ask spreads. To exit a position, an investor needs to hit a bid; to enter, an investor needs to lift an offer. The creation/redemption mechanism keeps these values generally close to NAVs, but for a variety of reasons, transactions can occur away from the theoretical value of the sum of ETP underlyings. In some cases, these fees can make trading prohibitive, but again this is a topic for a future article.
Suffice to say, ETPs function sufficiently well to allow for both long- and short-term trading. These passive investment products are so valuable that they have created a multi-trillion dollar global industry on their own, showing the strides passive investing has made since the 1980s before the first ETPs were created. These funds do not merely contain significant assets under management, but make up 10% of market capitalization on US exchanges and 30% of daily trading volumes (Ben-David et al.). The resulting ecosystem of index providers, ETP issuers, market makers, investors, and extensive intermediary teams has become very wealthy. Below, we discuss how ETP trading trends have shaped markets.
Impacts of the ETP Trading
Parsing the impact of ETPs on trading habits in general is a challenging academic exercise. Whether they exacerbate volatility, increase correlation in assets, or improve price discovery is hard to answer (though there are many attempts in the literature), but it is clear ETPs are one of the most important innovations in financial markets in recent memory. In the US, ETPs make up 20% of all short interest and account for a significant portion of trading volumes. More importantly, they have transformed markets.
Case Study: Corporate Debt
Bonds and other types of debt typically trade in over-the-counter transactions, making them inaccessible to most investors. ETPs led to a paradigm shift in market access. As Samara Cohen, Chief Investment of Index Funds at BlackRock, said during the Ondo Summit in 2025, “You can’t have a credible conversation in the bond market without knowing what an ETF is.”
Where there are around 4000 distinct stocks, there are millions of bonds. Banks around the country help corporations fund their businesses through debt, with each issuance having unique term sheets and underlying risk factors. The amount of diligence required to pick winning bonds is impractical for even the most specialized investors. For this reason, individual bonds are extremely illiquid.
To increase investor access to these important instruments, which thereby reduces the cost of capital for corporations (similarly individual loans, municipal debt, etc.), asset managers have increasingly turned to the ETP market. Beginning in 2002 with LQD, the fixed income ETP market has swelled, encouraging greater market sophistication. Total US fixed income ETP assets have doubled in the past five years.
Those historically trading fixed income products are very distinct from the high frequency trading firms dominating the ETP market space. Fixed-income traders once profited from strong relationships and high degrees of fragmentation. The ecosystem is now rapidly changing, with spreads tightening and more entrants flocking to the space as high frequency traders innovate on the pricing of these products. The changes in the market benefit everyone except for those taking excess rents from market inefficiencies, with institutions like ICE, BlackRock, State Street, and others celebrating these changes.
Bitcoin and Ethereum
Starting January 10, 2024, Bitcoin could be traded on exchange for the first time in an ETP wrapper. Unlike most ETPs, these products don’t exist to allow for passive investing, diversification, or exposure to active management; they are important simply because they allow investors who are restricted to equity investing, or those who do not want to interact directly on-chain, to receive exposure to the exciting opportunities in crypto assets.
When crypto ETPs were able to be listed, markets demonstrated an interesting phenomenon: while crypto fundamentals had not changed in the slightest, the price of Bitcoin soared. Simply creating an ETP product unlocked liquidity, impacting the crypto market similar to the changes seen over years in debt markets. (Shalvardjiev) Ethereum markets demonstrated these dynamics to a lesser extent, but we predict that as ETPs enable investments into new markets, we will see similar dynamics as pent up demand is able to be released.
New Frontiers
The changes to passive investing have been rapid over the past decades, though we believe the space has ample room to develop going forward. Below we specify a few.
Access
For the most part, ETPs are only available in their country of origin due to exchange access. In Europe, investors hoping to buy local funds tracking the S&P 500 need to pay higher fees to purchase SPY or IVV. If they want to buy local shares, they purchase UCITS (we will have a brief article on these shortly) like CSPX LN which have higher fees than US based counterparts despite functioning near identically. To proceed with trades, investors need to stomach these extra fees, preventing trades that issuers, market makers, and end investors would all prefer.
Not every market even has access to UCITS or ability to trade funds when exchanges are open, all preventing valuable trading. In order to truly democratize finance, making markets more efficient by allocating funds to the optimal opportunities, ETPs need to be able to be traded 24/7 and globally. Unfortunately, traditional finance rails do not allow for these opportunities.
Tick Size
In US markets, the smallest price increment an ETP can be quoted is $0.01. Other markets have similar restrictions. Even if the tick size were reduced, for some funds this can represent a significant cost. Take for instance the fund BTC. This was spun off from Grayscale’s Bitcoin ETP, GBTC, in order to allow smaller investors to purchase Bitcoin “for the price of hamburger” (the fund started with NAV around $5). This fund had lower fees than its bigger counterpart, encouraging investment. Nonetheless, institutional traders would not invest in this fund because the cost of purchasing a single share was around 20 bps, a significant cost compared to the 1 bp or so fee of GBTC at the time. We will discuss this example further, but for now we can comment that the significantly smaller tick size on crypto exchange will allow for better pricing and therefore easier trading of funds. While liquid funds now frequently trade “touch/touch” (the bid/ask spread is one cent), we predict funds will not trade at the smallest pricing increment on-chain, making efficient pricing far more important for traders than the current race-to-the-bottom in terms of speed that blocks new entrants from joining markets.
Reducing Tracking Error
It took over a decade for the illiquid bond market to receive close to the same tracking error that we see in equity markets. While there are days when the premium/discount blows out on ETPs like JNK as shown above, they have collapsed to a relatively stable range. The rails of traditional finance support such trends for ETPs with underlyings that trade on exchange. However, certain underlying products cannot achieve the same level of liquidity, ensuring that closing prices never converge to tight levels like those of SPY and JNK.
ETPs can hold practically anything. Equities, futures, and debt are common, but some issuers get more creative. One of the fastest growing ETP spaces currently is buffer funds. These funds cap downside by holding options. For the most part, options are exchange traded, making price replication fairly easy, but many funds hold what are called “flex” options. These are not exchange traded, meaning that matching their price is very hard, as we see below in the premium/discount chart for one such fund, BMAY.
Other funds hold swaps on indices that are not easy to discern publicly, such as BDRY which holds swaps on shipping contracts.
These products have high premia and discounts as well as high spreads, each reflecting costs to either enter or exit the position. Mutual funds do not have to deal with these costs because all transactions are managed by fund advisors, so to effectively unlock liquidity using ETPs, both the spread and discount need to be closely centered around the NAV.
The above funds are relatively complex, but Bitcoin and Ethereum funds are around as simple as it gets, with orders of magnitude fewer components necessary to price relative to SPY and JNK. Even though the underlying components are exchange-traded, these funds trade at significant premia/discounts for another reason: an on-chain asset is being wrapped off-chain. Instead of easily interoperable and similar rails, crypto ETPs need to deal with very different infrastructure. Below, we can see the premium/discount chart for USDU (an ETF with thirteen currency underlyings) and IBIT (an ETP with just one currency underlying, Bitcoin).
As we can see from these two graphs, IBIT trades at far greater premia and discounts than USDU, even though it trades at significantly higher volumes. While it might seem that this price discrepancy is related to the volatility of Bitcoin, market makers are theoretically always hedged, making volatility unimportant for the premia/discounts (volatility should only impact spread, with both ETPs generally trading at the tightest levels possible on exchange). The true reasoning for this relatively high tracking error is a function of the creation/redemption mechanism. For now, we will suffice to say by improving this mechanism, we can improve the pricing efficiency.
IBIT and other ETPs of its ilk like BITB and ETHA are the most simple possible crypto funds. As more assets enter these funds, as would be necessary to construct the CoinDesk20 Index (see our paper on the importance of indices), the divergence from fair value will only increase. In the coming weeks, we will lay out our plans of how we can tighten this gap.
New Assets
As more assets get tokenized to reduce intermediary costs, we imagine that ETPs will be the tool necessary to help them achieve huge boosts in liquidity as with Bitcoin, Ethereum, and corporate debt. Organizations like BlackRock and Apollo are increasingly adopting blockchain technology to reduce their costs by partnering with organizations like Ondo and Plume to put their assets on chain. To fully utilize these assets and create new markets, we imagine issuers will need to issue ETPs. However, we do not want these products to be overly costly due to lack of ability for market makers to trade them, as with IBIT and BDRY alike. This means that companies like Ondo cannot succeed in improving ETPs by making a tokenized version of SPY, as the difference between TradFi and DeFi rails will lead to higher costs as we saw with IBIT. We believe the solution lies on chain, as we will sketch out in future articles.
Conclusion
For centuries, financial markets have ensured efficient allocations of capital, from fixed income to equity to futures. The riskiness of these assets prevented their widespread adoption of a public willing to invest. We see this impact of this hurdle through the success of mutual funds and eventually ETPs. Beyond encouraging diversification, passive investment vehicles have also resulted in markets growing increasingly efficient, reducing costs for the entire economies. A tangible benefit of these savings is more financial stability and greater savings for retirees. However, we believe that passive investing still has room to evolve, particularly as more assets move on chain. Over the coming months, we will expand on this thesis and provide an explanation of our solution.
References
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Shalvardjiev, Dimiter, How Bitcoin Etfs Affect Spot Prices. Available at SSRN: https://ssrn.com/abstract=5115838 or http://dx.doi.org/10.2139/ssrn.5115838