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History of ETFs - Part 2

Updated: Jan 28, 2021

In the last article (History of ETFs - Part 1) we looked at how Black Monday (the stock market crash of 1987) was instrumental in ETFs getting started. The idea came out of 2 AMEX (American Stock Exchange) product development gurus seeing an SEC report on the event and the steps they had to go through to create the beloved product we have today. In today's session we look at what happened after that initial approval to create the first ETF (which was SPY) in 1993.

As a reminder, the details in this article mainly come from the great work done by Bloomberg in their special podcast, "The ETF Story" available here:

The Competition

We start with how The Palo Alto Research Center (PARC), who Steve Jobs visited and gained ideas to create the first Apple Mac, resonates with the story of ETFs. In this case, the 1987 Market Break report was instrumental in the creation of the ETF by Nate Most and Steve Bloom.

Others also tried to come up with collective investments that traded like stocks. There were products like SuperShares and TIPs which all could have turned into the main way of trading baskets of stocks we now know as ETFs. There were firms like Leland, O'Brien and Rubinstein that held portfolio insurance products (which were credited with contributing to Black Monday). They had, what they say, was the initial idea for ETFs in the form of SuperShares. They then took that idea to the AMEX under a handshake agrement of not having AMEX compete but said that the latter didn't hold up their end of the bargain.

Whilst SPY was waiting for approval - the TIPS product (Toronto Index Participation Shares) was launched in 1990 (before SPY approval). With a more liberal regulatory body in Canada, the approval process only took a year. This ran with no MER (management expense ratio) as it was a way to give retail investors access to the market at a low cost (a feature that is an advantage of ETFs to this day). However, the biggest influence for TIPS was the Philadelphia Exchange launching CIPS (cash index participation securities) and who struggled to get this through to the SEC. They ended up trying this in Canada instead and we got TIPS.

Regardless of all this, one thing that is unarguable, is that AMEX drove the initial push of ETFs to the wider market. These other products had trouble getting out to a wider audience whether through regulatory or popularity issues so SPY enduring what the others couldn't, they deserve to be considered the grandfather of ETFs.

If anything, there is a lesson in execution here. Others had great ideas but it was SPY that was built to be a better product, despite taking longer to get to market. It tracked a more well-known index (full replication of the S&P 500), went through more regulatory hoops to get over the line and was a very simple product which all added towards making it a stronger product than the competition.

SPY is now the largest ETF in the world with over $270 billion in assets (at the time of the podcast).

What a journey!

The Sleeper

In this episode we jump straight back into how SPY launched to much fanfare. But, after the initial trades it went quiet. Volume went down to only 18k trades a day over the next 6 months and rumours it would close were high. Adoption was the key to improvement.

The key to improving usage was done by word of mouth and having people see how they could get a good value product at a lower rate than the usual 100bps (basis points) as SPY traded at 25bps.

Brokers weren't rewarded in other means for this so the only way to popularise this was through word of mouth. Guerilla marketing helped but it neede more. With the economy improving in 1994/95 this also helped push things along from just the initial advocates to the other non-believers. The typical adoption curve would be apt here.

There was skepticism of having this work on a more widespread basis by all market participants. So it needed to have more than just 1 type of trade at a time, it needed more instruments to trade, more ETFs.

The next ETF to come aboard after the SPDR SPY was another arachnid named one called WEBS (World Equity Benchmark Shares) created by Morgan Stanley. It was through the WEBS prospectus that we first see the name ETF or exchange traded fund. WEBS was also driven by client demand and not just innovation like the SPY ETF was.

WEBS was unique in that it didn'f follow the same wrapper and UIT (unit investment trust) process as SPY and had tracked the various MSCI foreign stock market indice. They instead used mutual funds which were less restrictive than UITs were when working with international markets.

WEBS was eventually sold to Barclays for the princely sum of $1. Barclays looked for where the trap was for this but found none. Morgan Stanley just did not find the product that valuable. WEBS rebranded as iShares which we still see today.

The new owners saw that these products could be used to solve many market problems including asset allocation and the investment needs for clients. This would include giving retail clients access to market exposures that they would not get from just buying stocks on their own.

iShares, through good marketing and being a useful product solving many market problems has become a well known household name (now under the BlackRock group) but it was SPY that started it all.

Additional insights

More on PARC

The New Yorker has a great article on the PARC / Apple visit which is largely credited with giving Steve Jobs the idea for what became the Apple Macintosh. It's called Creation Myth and is available here:

More on TIPS

One of the competitors to ETFs was the TIPS product out of Canada and you can read more about the history of that product on Investopedia ((which you can read more about here: Investopedia is a great website, full of lots of information on investing.

If you look at ETFs as a search term you get an abundance of insights from the very basic...

to more advanced...

In the next blog we'll look at "The Revolution" episode and also look at where the current ETF climate is right now in 2021.

Stay tuned!

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