WHEN the first exchange-traded fund (ETF) hit the market in 1990, it caused barely a ripple in the world of investing. But if ETFs continue to enjoy the spectacular rates of growth they have seen over the past five years that year may one day be seen as one of the asset-management industry's milestones, along with such landmarks as 1774 (when a Dutch merchant cobbled together the earliest mutual-style fund, Eendragt Maakt Magt, or Unity Creates Strength) and 1924 (the launch in Boston of the first modern mutual fund).

Assets held by American-listed ETFs rose by a shade under 40% last year to $418 billion. By the end of March they had climbed by a further $22 billion. Although these upstart funds are still dwarfed by their mutual cousins, which hold over $10 trillion, their share of the indexed market is booming (see chart). Deborah Fuhr of Morgan Stanley predicts that they will have $2 trillion under their wing by 2011. They have become a formidable force in stockmarkets too: last year, more than 8% of all trading in American equities was done through ETFs. But as it expands and evolves, the sector may be riding for a fall, some critics say.

ETFs are part fund, part stock. Like an index mutual fund, they track baskets of assets, such as stockmarket indexes or commodities. But unlike standard funds they can be bought and sold throughout the trading day, so investors can make, or reverse, broad bets quickly, without having to buy dozens of stocks separately. Hedge funds are enthusiastic users, lured not only by the combination of diversification and trading convenience, but also by rules that allow ETFs to be sold short as they are falling, unlike individual shares, which can only be shorted on an “uptick”. Individuals are increasingly getting in on the act too. Big providers of ETFs, such as Barclays Global Investors (BGI) and State Street, say that retail investors now account for two-thirds of inflows, double their share of five years ago. They are attracted by low fees—around a quarter of a percentage point on average—tax advantages and efficient pricing. Portfolios are rebalanced throughout the day so ETFs trade at or close to the net value of their assets, unlike many mutual funds.

Lee Kranefuss of BGI argues that ETFs are to mutual funds what he reckons compact discs were to records: “a better product with more features for less money.” They are also a force for financial democratisation, he says, since investors big and small can trade on the same terms. And they allow investors to get “beta” (market returns) on the cheap, while active managers toil in search of “alpha” (extra returns through skill), charging more for the privilege—and all too often failing to deliver.

The popularity of ETFs has led to a frenzy of launches. More of them have been unveiled since the beginning of 2006 than in all previous years combined. So far this year, more than 95 have started trading on American markets alone, many of these on the New York Stock Exchange, which sees ETF listings as a key source of listings income. Hundreds more are awaiting approval from the Securities and Exchange Commission (which, worryingly, cannot provide a precise number).

As they expand, providers are pushing into new areas—and, as BGI's Matt Scanlan puts it, “slicing the baloney thinner”. BGI and Vanguard have begun offering fixed-income ETFs; BGI recently launched one that tracks junk bonds. In stocks, it is no longer enough to track the obvious indexes, such as the S&P 500 or the Nikkei. The ETF firms' eggheads have been working overtime to create customised baskets that approximate particular industries or asset classes. There are ETFs that track spin-offs, private equity, gold, vaccine stocks, intellectual property, nanotechnology, clean energy, and much more. Others are designed to allow intriguing bets on standard indexes: the ProShares UltraShort QQQ, for instance, is a “double inverse” play on the NASDAQ 100. Investors gain 2% when the index falls 1%, and vice versa.

This narrowing of focus has given individuals easy access to sectors, such as gold and private equity, that were hard for the unsophisticated investor to reach. State Street's gold ETF has been one of the industry's most popular funds.

However, some worry that growth is getting out of hand, with valuations that recall the dotcom bubble. One ETF provider, WisdomTree, has seen the company's own share price rise by 80% over the past year, even though it is yet to post a profit. Concern is also growing that investors do not appreciate the risks of the ballooning array of niche ETFs. Because they are more thinly traded than flagships such as State Street's S&P 500-tracking SPDR, the world's most liquid share, it costs more to move in and out of them.

Moreover, they may not be tracking their chosen market segments as closely as investors think. A fund with 100 holdings might have over half of its assets concentrated in five or six stocks. Some ETF firms try to replicate entire sectors with a few stocks. They argue that these are always chosen carefully to be representative. But sceptics see it as more akin to the stock picking of active managers than the diversification promised by index funds. In several recent cases—such as oil and Chinese stocks—ETF prices have drifted from those of the underlying assets.

The most vocal critic of ETFs is John Bogle, Vanguard's former boss. He likens them to a shotgun: “good for hunting game, but good for suicide too”. He thinks they are undermining the buy-and-hold principle of sound investing by tempting the little guy into ill-timed “performance-chasing”. And he is horrified that some funds see turnover of more than 3,000% a year. The trading commissions notched up by all this activity could overwhelm the cost advantages of ETFs, he argues.

Sceptics, like Mr Bogle, have got it wrong, according to Mr Kranefuss. The vast majority of trading is done by institutions, not individuals. And the rapid-fire trading by hedge funds actually helps small investors, because it creates liquidity that drives down spreads. In any case, a class of fund is not bad just because it brings with it the potential to invest unwisely. ETFs are “just another tool in the box,” says James Kelly of Kelly Capital Management. “And any tool can be misused.” Still, ETF firms, fearful of a backlash, have been spending heavily on educating investors about the possible pitfalls.

None of this is likely to slow the pace of innovation. A big challenge for the industry is to create a fully active ETF that is able to move in and out of individual stocks, like a traditional mutual fund, while being tradable, like a stock. BGI and State Street have teams working on the problem—a problem because ETFs are inherently transparent, whereas active funds guard their strategies jealously, fearful that they will be copied. If active ETFs can be made to work, and receive the SEC's blessing, they could take the business to a new level.

Another attractive area is retirement accounts, where ETFs have the potential to become much bigger. They have already made headway in some emerging markets. Since Mexico allowed ETFs into its retirement system, Barclays' iShares Funds have come to account for some 15% of all trading on its stockmarket.

Mr Kranefuss touts ETFs as a “paradigm-buster”. Such claims should always be treated with caution. But who would bet against his assertion that they will one day match traditional mutual funds in size and influence?