Happy 30th birthday to the ETF*
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
As the asterisk hints, the headline is not quite correct. One of the ETF industry’s favourite supposedly obscure but actually pretty well-known factoids is that the first ETF was born in Canada, on March 9, 1990.
But the almost $10tn ETFs industry’s true progenitor is unquestionably the SPDR S&P 500 ETF Trust, which was born with $6.5mn of seed money three decades ago today (and first started trading a week later, on Jan 29).
Why? Because the crafty Canadians basically just copied the basic design of the American Stock Exchange, which had engineered the product in conjunction with State Street to reinvigorate the struggling bourse. The SPDR team had filed the prospectus in early 1990, but it took nearly three long years of regulatory rigmarole before the SEC finally approved it.
Nathan Most, the Amex’s head of new products development and father of the ETF, is no longer with us, but at least he got to see his invention take flight — something that undoubtedly made the former submariner feel pretty proud. As ‘Nate’ Most told Worth Magazine shortly before SPDR finally went live:
“When you see your ‘babies’ trading down on the floor, you feel a real attachment to your work that most people in this world of money never get to experience.”
The basic idea behind ETFs came from Most’s time working around Asia, first working in the cooking oil business and then the now-defunct Pacific Commodities Exchange.
He had observed how commodity traders bought and sold warehouse receipts of ingots of gold or coconut oil vats rather than lugging around the physical goods from place to place. As he told ETF.com’s Jim Wiandt:
“You store a commodity and you get a warehouse receipt and you can finance on that warehouse receipt. You can sell it, do a lot of things with it. Because you don’t want to be moving the merchandise back and forth all the time, so you keep it in place and you simply transfer the warehouse receipt.”
This is basically what the ETF is: a legal warehouse within which you can put pretty much anything, from stocks and bonds to physical commodities and financial derivatives. The warehouse manager/fund provider and market makers known as “authorised” participants” then create or redeem shares in the warehouse depending on demand.
By the late 1980s the Amex was in desperate need for something to reinvigorate trading. Inspired by the SEC’s postmortem on 1987’s Black Monday Crash, Most and his colleague Steven Bloom started to design a tradable index fund based on the warehouse receipt idea. Here’s a great piece by Bloomberg’s Eric Balchunas on SPDR’s genesis:
One particular section of Chapter 3 caught Bloom’s attention. There, the SEC suggested that “an alternative approach be examined” and posited that if well-capitalized specialists and supplementary market makers could have turned to a single “product” for trading baskets of stocks, the market damage — and volatility — may have been significantly smaller. Indeed, such a product might even have prevented the crash by providing a liquidity buffer between the futures market and individual stocks. “I walked into Nate’s office and said, ‘Here’s an opening we could drive a truck through,’ ” Bloom says.
Despite years of development work and a huge marketing blitz — including a huge nine-foot spider strung up over the Amex trading floor at Wall Street’s Trinity Place — the initial reception was as frosty as the gestation was long and troubled.
The ETF gathered assets slowly, and trading volumes — the reason why the Amex conjured it up in the first place — were dire. By the summer of 1993 trading hit a nadir of just 17,900 shares changing hands. Given that it needed a certain level of assets and trading to be financially sustainable, State Street and the Amex even considered killing it.
It’s a good thing they didn’t. The ETF often just known as SPY due to its stock market ticker (or “Spider” because of the SPDR acronym) now manages $371bn. That makes it the biggest ETF in the world, and bigger than any actively-managed fund (it is more than three times the size of Peter Lynch’s Magellan fund was at its peak).
And although it might sooner or later be overtaken in size by Vanguard and BlackRock’s rival S&P 500 ETFs, $SPY’s status as the most actively-traded equity security in the planet looks secure.
Last year it clocked average daily trading volumes of $39bn, over three times as much as Apple’s stock. Because of this there is also A vibrant ecosystem of related derivatives built on top of the SPDR S&P 500 ETF Trust.
Jack Bogle was famously no fan of ETFs, and in fact turned down Most when the Amex at first sought to partner with index fund giant Vanguard before turning to State Street. But Bogle later was forced to admit its significance:
“I had no idea that, within a decade, the ETF idea would ignite a flame that would change not only the nature of indexing, but also the entire field of investing. I can unhesitatingly describe Nathan Most’s visionary creation of the ETF as the most successful financial marketing idea so far during the twenty-first century. Whether it proves to be the most successful investment idea of the century remains to be seen.”
To the end of his days Bogle remained sceptical of ETFs — even if he grudgingly admitted that it had helped more people embrace the passive investing revolution — but it’s hard to say that the ETF hasn’t proven much more than a marketing wheeze.
As FT Alphaville has written, the ETF is now even threatening to supplant the classic mutual fund structure as the vehicle of choice for asset managers. In the US it has already done so:
A bit like how there will always be one insufferable nerd at the party that insists that band X is actually just a commercial knock-off of Y, there are some that point to earlier incarnations of the ETF as the true parent.
Aside from Canada’s TIPS, some people will point to the SuperShares project of LOR, a financial engineering firm set up by Hayne Leland, John O’Brien and Mark Rubinstein. LOR is probably best known as the parent of “portfolio insurance”, and although SuperShares went live before TIPS and SPDR — and in fact furrowed a legal passage for the latter — it was too complicated to take off.
Similarly, the “index participation shares” launched by the likes of the Philadelphia Stock Exchange, Cboe and the Amex in the late 1980s were promising, but quickly killed by a regulatory spat between the CFTC and the SEC. SPDR owes something to all its antecedents, but is the acorn from which a mighty oak grew.
The ETF industry has clearly gone beyond ‘interesting innovation’ territory and is now deep in ‘throw shit against the wall and see what sticks’ terra incognita, but there doesn’t seem to be much that can dent its trajectory.
So here’s to the SPDR S&P 500 ETF Trust. For better or worse, its place in the financial history books is assured.