Michelangelo: The Creation of Adam. Source: Wikipedia
Exchange Traded Funds, or ETFs, have taken the market by storm. On average, SPY–the first (and largest ETF by assets)–trades over 150 million shares each day. That’s more than the 20 most-traded stocks combined. There’s over $3 trillion invested in ETFs, shares that cover stocks, bonds, commodities, currencies, real-estate, limited partnerships, and so on. Once we got our smart phones, the go-to phrase was, “There’s an app for that.” Well, when it comes to investing, it seems now that “There’s an ETF for that as” well.
But how did this happen? Where did this industry come from? A recent Bloomberg story outlines the history of the first ETF. In the aftermath of the 1987 stock market crash, the SEC produced a report that pointed the finger squarely at a market practice known as “portfolio insurance.” The idea was that if investors sold futures contracts in increasing amounts as the market fell, they could “insure” the value of their portfolios. But when the market broke, and investors panicked, there was a giant rush for the exits. Not many could get through, and the result was the largest one-day drop in market history—over 22%, or 3700 points on the Dow today.
The SEC suggested that if someone created a single product that contained a broad basket of stocks, the damage—and volatility—would have been a lot less. They also hinted that they might expedite the approval process.
At the time, the American Stock Exchange was struggling for relevance. Only a small number of big companies still listed their shares on the AMEX—best known at the time for still using hand signals to communicate with specialists on the floor. They lagged far behind the New York Stock Exchange and the NASDAQ in both listings and relevance.
So when an executive from AMEX reviewed the SEC’s analysis of Black Monday, he saw an opening for a new product that could revive the exchange’s fortunes. The result was a fund based on the S&P 500—the most widely used index—they called S&P Depository Receipts, or SPDRs. The promise of expedited treatment turned out to be a false flag, though. The SEC treated SPDRs as a Unit Investment Trust, and it took over 5 years for them to approve the product. After filing their application, the originators mentioned their idea to some folks at the Toronto Stock Exchange. The Canadians got their version up and running three years before the Americans did.
The rest is history. ETFs turned out to be useful for a lot more than portfolio insurance. Initially, they were based on broad indices. QQQ, the NASDAQ-100 based ETF, was highly popular during the dot-com era. Now there are over 6500 different ETFs that trade on more than 600 exchanges—active funds, passive funds, levered funds, and inverse funds, that go up when the market goes down. ETFs have democratized investing, making it simple and inexpensive to buy a fund that invests in the whole world, or one that invests in only Chinese consumer discretionary stocks. All the you need is a brokerage account.
There’s no free lunch, though. ETFs have been implicated in “flash-crashes,” where normally stable stocks suddenly sell for pennies on the dollar. Excessive flows in an out of the funds can also cause them to diverge significantly from their underlying value. And John Bogle, creator of the first index-based mutual fund, has noted that the temptation to speculate in ETFs causes investors to lose what they gain from broad diversification.
But ETFs seem to be a permanent part of the financial landscape. What started out as a product has become an entire industry. Most financial advisors use them in one way or another, if only to compare their portfolios with something. Just remember: there’s nothing truly new under the sun. All financial products have multiple types of risks. And just when you think you’ve found the key to the market, they change the lock.
Douglas R. Tengdin, CFA
Chief Investment Officer
Charter Trust Company