It is the winter of 2002, and I’m sitting in the half-empty boardroom of a hollowed-out brokerage firm. Investors had spent the past year pulling a net $27 billion from stock mutual funds. The brokerage industry has been utterly ravaged by the successive backbreaking events of the dot-com crash, 9/11, and that matched set of accounting debacles, Enron and WorldCom. Fully half of the guys I came up with in the business had left by this point; they were off selling insurance or mortgages or whatever else was a more readily received proposition than common stocks. Now that widely held fallen angels like Cisco, Lucent, Sun Microsystems, Palm, and AOL Time Warner had broken all our hearts, the American public was disgusted with the stock market, and there was not a single exciting thing for us to talk about to turn the public around.
The Fed had cut rates to extraordinarily low levels, which was starting to be felt in the real estate market, but in Stockbrokerville we were just absolutely decimated. No one wanted to hear from us, period.
And into these ruins strode a heavyset man wearing a matching navy blue polo shirt and ball cap, each emblazoned with a spider logo. He had a box of sales literature under his arm. The partners had grudgingly given him this time to come in and make a presentation to our gutted sales force about an innovative new product that could possibly change our fortunes.
“Good afternoon, gents,” the man said, as my fellow brokers barely looked up to acknowledge his presence. “I work for the American Stock Exchange, and I’m here to tell you guys about a brand-new way to invest your clients’ money that’s cheaper and more efficient than whatever you’re doing now.”
“Yeah, what’s the commission? If it ain’t 5 percent, you’re in the wrong place, pal.”
Amex Guy ignores the guido with the thick Brooklyn accent and the even thicker Gucci tie. “How many of you guys are familiar with the SPDR, or Spyder S&P fund, that trades like a stock?”
A few hands go up, and someone in the back of the room belches. You can hear clicking on keyboards as the apathy in the room manifests itself in the sound of Web surfing.
“Well, what if I told you that on the Amex, we’re beginning to trade dozens of versions of the SPDR that will allow you to buy and sell entire indexes and specific sectors in a single trade?”
The keyboard clicking stops, and a few heads lift off the desks.
“What if I said that with a single order ticket you could be long or short the entire oil and gas sector rather than a specific stock? What if I told you there was a way to buy the entire NASDAQ 100 without using index options or an index mutual fund that locks your clients’ money in?”
Now he had us. Those of us who were left, anyway. A liquid way to be in and out of the indexes without locking up client money in a mutual fund meant huge money in commissions for active trading accounts. It meant building positions for clients without exposing ourselves to single-stock risk. Amex Guy may have looked like a schlub, but he just pulled a Ferrari up to our driveway and handed us the keys.
“Do yourselves a favor and have a look at this list of the exchange-traded funds that are currently trading. There are way more of them now than just the S&P Spyder fund, and I’m telling you guys, this is the future. And here are some SPDR ball caps courtesy of the American Stock Exchange. You have a good night.”
That was 10 years ago. That gentleman from the Amex wasn’t kidding around. Though we only had an inkling at the time, these new ETFs would change everything. They would captivate the do-it-yourselfers and become the go-to option for the pros. They would wrench the vaunted mutual fund from its seemingly unassailable pedestal high above the investing landscape. They would go on to alter the very fabric of the capital markets themselves. The ETF would become the greatest financial innovation since the open-end mutual fund’s genesis in 1924.
Structurally speaking, the ETF looks like a closed-end fund in that it is bought and sold all day on an exchange. But unlike the closed-end fund, which can and will trade at either a discount or a premium to its holdings at any given moment, the ETF is designed to trade to within pennies of its actual net asset value at all times. The goal is for the ETF to move about all day in concert with the basket of stocks or the index that it’s supposed to replicate with as little “tracking error” as possible. It does this through a mechanism called creation/redemption, which we’ll not get bogged down with here. Suffice it to say that the vast majority of plain-vanilla index and sector ETFs are extremely efficient in this regard.
Because the ETF’s price is meant to accurately reflect its net asset value, it is more akin to the mutual fund—but with one major mechanical difference. ETFs offer all-day liquidity and can be bought and sold like a stock with no penalties or lingering consequences. In contrast, mutual fund investors must wait until the close of business for their buy and sell orders to be filled. Mutual funds can have all kinds of backdoor fees involved with selling, depending on what share class you’re in and how long you hold the funds. The end result is that investors can be more nimble and fleet-footed when necessary with an ETF over a more traditional fund.
In terms of cost advantages, the ETF has every other investment company structure beat by a mile. It has a significantly lower expense ratio than the mutual fund because it doesn’t have to invest cash contributions, fund cash redemptions, maintain reserves for redemptions, or pay big brokerage costs. Whereas mutual funds typically charge 1 to 3 percent on the assets you invest with them, most ETFs only cost somewhere in the 0.1 to 1 percent range. True, 1 percent may sound inconsequential in the scheme of things until you consider the impact on a portfolio over longer time frames. The U.S. Government Accountability Office did a report on 401(k) fees in 2009, and it concluded that by paying an extra percentage point in annual fees, you were shaving around 16 percent off your accumulated retirement savings over a 20-year span. Now you add in the loads (commissions) associated with a broker-sold mutual fund, and the difference in cost is even more glaring. As Warren Buffett and many other market mavens repeatedly admonish, high expenses are one of the biggest contributors to poor investment performance over time. ETFs were tailor-made to address this very concern.
But despite these very obvious structural and cost advantages, ETFs were by no means a slam dunk when they were first conceived of. In fact, the product went through a tumultuous early evolution, and it almost didn’t survive.
The story of the ETF goes back to a primitive antecedent called the Index Participation Share (IPS) that debuted in 1989 on the American and Philadelphia Stock Exchanges. It was meant to be a product that would serve as a proxy for the S&P 500 Index, but its structure was flawed enough that it was eventually sued out of existence. Gary Gastineau tells us in his seminal book The Exchange-Traded Funds Manual that the Chicago Mercantile Exchange and the Commodity Futures Trading Commission successfully argued that these IPS vehicles were essentially a futures product and as such needed to trade on a futures exchange, which the Amex wasn’t. Gastineau notes one other notable attempt, the SuperShares product launched by Leland, O’Brien, Rubinstein Associates. This product never really got off the ground because of its unexplainable structure, its high cost, and a skeptical environment in the wake of the 1987 crash that had been precipitated by the portfolio insurance fad.
But in 1993 a pair of American Stock Exchange executives finally get it right. They launch the SPDR fund that will track the performance of the S&P 500 Index at a lower cost and higher level of efficiency than that of the traditional index mutual funds that John Bogle had revolutionized in the 1970s at Vanguard. Nathan Most and Steven Bloom introduce their Spyder ETF in January 1993, and it goes on to become the granddaddy of ETFs, spawning a long line of descendants starting with the MidCap SPDRs in May 1995.
The Global Investors unit of Barclays Bank gets into the ETF game in 1996 with a set of 17 funds that will track each of the Morgan Stanley Country Index markets. For the first time investors can buy and sell entire foreign countries with a click, an ability we now take for granted. These Barclays ETFs will become known as the iShares family, still one of the largest lineups of ETFs to this day.
Within the next two years, mutual fund pioneer State Street will introduce the sector SPDRs, one for each of the nine sectors of the S&P 500. We’ll also see the introduction of a Dow Jones–tracking ETF—the DIA, or “Diamonds”—as well as QQQ NASDAQ index fund, affectionately known as the “Cubes.”
Vanguard, which should have been an early adherent of the product given its super-low cost structure, passive characteristics, and transparency, doesn’t get into the game until 2005 when Bogle retires. His reactionary screeds against the ETF revolution in the press serve as a sad episode in an otherwise storied career. He will eventually relent and acknowledge the utility of the exchange-traded structure, but by this time it is Barclays iShares that wears the ETF assets-under-management crown.
The growth of the industry in just the last decade is like nothing seen since the war bond craze that created the Wall Street–Main Street nexus to begin with. According to an April 2011 research report from the Financial Stability Board:
At the end of Q3 2010, the global ETF industry had $1.2 trillion in assets under management, 85% in plain-vanilla ETFs referenced to equity indices, which is equivalent to 5% of global mutual fund assets and 2% of global equity market capitalisation. The industry has grown at an average of 40% a year over the past 10 years, which dwarfs the growth rate of both global mutual funds and equity markets (around 5% a year). Most ETFs are listed on US and European exchanges, but they provide exposure to a much more diverse range of markets (e.g., two of the three largest ETFs worldwide track emerging market indices).
At last count, there were 916 ETFs on U.S. exchanges. The original SPDR is still the heavyweight champ, weighing in at $89 billion in assets under management; by some measurements, it holds 7.5 percent of all assets in the entire ETF market. Its cousin GLD, the SPDR Gold Shares ETF, is a distant second place with $58 billion followed by Vanguard’s Emerging Markets ETF with $47 billion under management. With products like these trading tens of millions of shares a day and garnering billions in net new inflows, it’s safe to say that the ETF is now a permanent part of the firmament. These products have gone from being an alternative structure to gaining widespread acceptance among both self-directed investors and professional money managers in record time.