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History of ETFs - Part 3

In the last 2 History of ETF articles (History of ETFs - Part 1 and History of ETFs - Part 2) we looked at how ETFs got started out of the 1987 stock market crash and reporting on the fallout from the SEC. We also looked at the journey (took 6 years for SPY to go from application to approval) and rivals that ETFs had until they became the household name they are today.

In today's session we look at the innovation that started coming out in the ETF markets. We continue to track "The ETF Story" podcast from Bloomberg. One of those new innovations was a move away from just ETFs for equities but also for fixed income, LQD. This was the first ETF in the fixed income space and created by iShares. Knowing how long it took tot get approval for a run of the mill market product like SPY, an ETF for a non-transparent market in fixed income might also take a while to get going. However the benefit of a security which could be a reference point for that market was seen as a positive.

For these new products it took a while to get customers to use them. But the advantages could be seen once customers got in. The benefits were seen immediately. Instead of trying to assemble all your own corporate bonds in the case of LQD, you could simply buy that single instrument. Making corporate bonds an easier thing to buy was a benefit they saw for LQD and it's something we would see ETFs take advantage of over the next couple of decades.

Another launch at the time was the Vanguard Index Participation Receipts (VIPERs). Going back to episode 1, we saw that Vanguard founder Jack Bogle inspired the creation of the first ETFs but did not necessarily like them. Whilst Bogle did not like VIPRs necessarily, he could see the reason for it as it would create new revenue streams.

Vanguard giving the tick of approval to ETFs was seen as the door opening for a huge rush into ETFs by other brands.

We also see PowerShares (by Invesco) launching and smart beta strategies being born. This was an ETF that instead of passively following an index, used a rules-based system to create a similar type of index but focused on certain factors like value. This led to more creative ETF strategies coming to market and it also is the era where we saw the first ETF evangelist, Rob Arnaut. His Invesco FTSE-RAFI 1000 fund or PRF (NYSEARCA:PRF) launched in 2005 and whilst important in and of itself, was more important as it brought Rob to the public eye. He was the person you could put on radio and stick in front of a TV camera to talk about smart beta ETFs.

Now investors started to see a wider range of choices to come to market for investors. Before that it was just index tracking funds and some sector funds but not much else.

Additionally, they mention that the development of new ETFs also meant something new for investors. Instead of just buying a couple of stocks, they now get access to real asset allocation indexes and the advantages that come through that type of money management.

Arnott mentions though that ETFs today are like too much choices at the grocery store. In terms of the future there are talks that the term "smart beta" may even be abandoned (especially as some are not really smart beta strategies under the hood). Instead, the idea would be to call them "quant active" or "quant" funds. We will see.

The story talks about projections as to where the markets could go to. For example $30trillion by 2030 globally. As of 2019 it was $6.2trillion (see Worldwide ETF Assets Under Management 2003-2019). In Australia, we saw ETF's grow to $94.4bn by the end of 2020 (see here: 2020 Year in Review for Aussie ETFs). The market has certainly grown globally and locally and we can look back at how far its come since the original ideas from Nate Most and Steve Bloom. Most passed away in 2004 at the age of 90 but a great quote that sums all of this up was from Bloom who said, "we tried to create a great product but it turned into an industry". And what an industry it has become!

More Insights - Smart Beta

According to Investopedia, a Smart Beta ETF "is a type of exchange-traded fund (ETF) that uses a rules-based system for selecting investments to be included in the fund portfolio. An exchange-traded fund or ETF is a type of fund that tracks an index such as the S&P 500. Smart beta ETFs build on traditional ETFs and tailor the components of the fund's holdings based on predetermined financial metrics."

There are various type of these ETFs including:

  • Equally weighted: Instead of weighting the fund based on stock price and market capitalization, this strategy equally weights the factors and each holding.

  • Fundamentally weighted: Companies are selected and weighted by such factors as total earnings, profits, revenue, or financially driven fundamentals and metrics.

  • Factor-based: Stocks are weighted based on specific factors such as balance sheet components, underpriced valuations, or smaller companies that are growing.

  • Low volatility: This method focuses on stocks and indexes with low volatility or small price fluctuations over a historical period.

For more insights into Smart Beta ETFs check out Investopedia's article on them here: -

More Insights - Institutional Investor on the 20th Birthday of ETFs in 2013

Check out this article from Institutional Investor back in 2013 where they looked at SPDR and do a dive into the ETF story:

Stay tuned for more educational ETF articles coming soon!

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