Globally, ETFs have been around for a long time (nearly 30 years) and 2020 was a record year as we could see in the Australian market (net inflows grew +145% to AU$33bn and overall funds under management hit AU$94.4bn - see 2020 Year in Review for Aussie ETFs). But even before this asset class became the market darling that it is, it had to go through its own growing pains as it got started.
In this series of articles we will primarily be looking at things through the lens of a podcast called "The ETF Story" from Bloomberg (https://open.spotify.com/show/0j03M8cOnnsI1nNfOTqPya) and overlaying it with other insights. This will hopefully give you a good picture of the journey that ETFs have endured.
The Report
Whilst the ETF story podcast starts off with the major stock market crash of 1987, the real story for ETFs begins with the epsidoe entitled "The Report". In it we larn how Nate Most and Steve Bloom got the idea for building the first exchanged traded product from an SEC (Securities and Exchange Commission) report calling for a product for trading baskets of stocks. Nate and Steve both worked together at AMEX (American Stock Exchange) in the product development team. They speak about the SEC basically creating the "sketch" or outline of what would help the market improve by having products that could be traded as a basket of goods and physically backed.
Most and Bloom created a prototype and took it to a few places including John Bogle at Vanguard (the father of index investing). Bogle initially passed on this pitch and identified 3 flaws in this initial version of the ETF idea and whilst they fixed the flaws, they went back to the drawing board.
Commodities played a big part in the history of ETFs too as, at the time, you could get a ticket for storing physical commodities known as commodity warehouse receipts). These receipts could be traded back and forth so replacing the commodity in this example with the S&P 500 gave Most and Bloom the idea for the first ETF. These assets could be traded back and forth without touching the physical commodity.
Now that the idea for how it would work was there they needed a name and settled on SPDR which stood for S&P and DR for depository receipts. This was now a new way of trading indexes but they were not alone. Others were also looking at ways to trade index funds but the key for SPDR was the creation redemption mechanism they included in their product filing with the SEC.
We're then introduced to Kathleen Moriarty who helped bring to life not just the first ETF but many iconic ones in the process.
The Approval
In the next episode "The Approval" we learn how it took over 4 years from the time the initial product was submitted to the SEC in 1988 to 1993 when it was finally approved. This episode looked at the all important legal stops needed to get there.
The most important part of the ETF process idea that Most and Bloom created was the creation redemption mechanism. Basically, this was bringing elements of the commodities world to the equities market. It was the warhouse receipt concept brought to the basket trading idea.
The steps are outlined in this episode too
a specific group of stocks are handed to a custodian in exchange for shares
those shares could be broken up and sold on an exchange
The inverse could also work
a group of shares could be bought on exchange
these could be then handed to a warehouse custodian to get a basket of stocks back
State Street came in as the provider of a trustee services and to act as the virtual warehouse. This sounds straight forward but it was not just about the mathematics of tracking a basket of stocks but there was also legal complexity as well. It was a legal spiderweb to launch the SPDR.
Kathleen Moriarty, a lawyer on the team was instrumental in getting things over the line by helping to structure SPDR and submit it to the SEC. Some other facets of this legal structure of the SPDR product were that changes in the individual stocks were reflected each day in the index. This was fine to do but meant they would need to file for the product as a UIT (unit investment trust). There was also a debate over whether this should be a managed fund instead but UITs were cheaper to run and did not need all the features that managed funds have. ETFs also had more restrictive investor protections they had to conform to and this played a part in holding up approval.
There was also some hesitancy on the SEC side of bringing new products to market especially when the fallout of the 1987 market crash was still fresh in many minds.
SPDR also offered significant tax benefits due to exemptions for in-kind exchanges (no money changing hands when shares created or redeemed). This was an unintended consequence and meant no capital gains.
On launch day at the NYSE (New York Stock Exchange) it traded 1 million shares. They hoped it would get $1 billion in assets. Only few traders and brokers knew about this so there was a lot more evangelising person to person needed.
Fun fact: When it first launched, SPY was not even known as an ETF as the name ETF would come along a few years later
Additional insights
If you're after a bit more of a visual history then check out Visual Capitalist and it's take on the 26 year history of ETFs from the first S&P 500 tracking one launched in 1993 up until 2019 where over 2,470+ U.S. listed ETFs.
From Key Milestones...
to how institutions use ETFs...
There are some great and interesting insights on their ETF page and you can check out here: https://www.visualcapitalist.com/the-26-year-history-of-etfs-in-one-infographic/#:~:text=1993%20%E2%80%93%20The%20First%20ETF%20launches,offering%20exposure%20to%20gold%20bullion
In the next blog we'll look at "The Competition" and "The Sleeper" episodes and learn more about the history of ETFs.