Abstract: Worldwide assets under management in exchange-traded products (ETPs) have seen explosive growth over the past decade. But where did they come from? The origins of ETPs can be traced back to the emergence of the mutual fund industry and subsequently traced through a series of financial innovations spurred by market crashes, liquidity crises, and depressions. ETPs were borne out of a desire for greater liquidity and flexibility. But ETPs’ structure, alone, does not account for the category’s success. Rather, the growing popularity of ETPs stems more from the behaviour of asset returns--namely, the observed difficulty associated with beating markets--and the consequential rise in use of passive investment vehicles.
Worldwide assets under management in exchange-traded products (ETPs) have seen explosive growth over the past decade, and their complexity seems to be increasing just as quickly. The emergence of ETPs and their subsequent popularisation has increased investor interest and in the process raised important questions about what ETPs are, how to analyse them, and how to use them. The commonly cited definition of an exchange-traded fund (ETF) is "a fund that trades on an exchange like a stock." However, to put ETPs into their proper historical context, we first need to revisit what mutual funds are and why they came to be. From there, we can address the genesis of ETFs and other ETPs.
Mutual funds first arose largely out of convenience. Groups of investors decided to pool their cash together into one portfolio because they did not have the time or the proficiency to invest their money in individual securities. With their collective funds pooled, investors were granted a number shares in the fund based on the amount of money they invested. The pooled fund was overseen by a competent manager who invested on their behalf. This structure offered several advantages versus investing in individual securities. First, it served to lower the cost of investing, thanks to efficiencies of scale stemming from the pooling of multiple investors’ assets. A second and directly related benefit was that investors were now able to own a greater number of distinct assets, i.e. diversify. Mathematically, the benefits of diversification can be derived with great precision and tend to result in higher returns and less risk per unit of currency invested.
The creation of the mutual fund structure is credited to a Dutch merchant in 1774 and followed a liquidity crisis in Amsterdam in 1772-3. The aim was to provide investors who had smaller amounts of capital the ability to pool their funds and, thereby, to increase their access to profitable ventures and decrease their investment risk via diversification. The fund was called "Eendragt Maakt Magt," or "Unity Creates Strength," and was diversified across 100 different assets in Europe, Central America, and South America. The fund lasted over 120 years and still holds the record for the longest-tenured investment vehicle of its kind to ever have existed.
Despite the early success of "Eendragt Maakt Magt," mutual funds didn’t become a really popular investment structure until the late 1920s in the US. Prior to the 1920s, US investors primary utilised investment trusts or closed-end fund structures to obtain diversification benefits. However, these structures restricted the creation and redemption of shares, and therefore, were much less responsive to investor demand to liquidate their holdings or invest more capital. As a result, shares of closed-end funds tended to trade at premiums or discounts to their underlying net asset value (NAV).
In the 1924, the Massachusetts Investment Trust (MIT) was created with an open-end structure that allowed for the regular creation and redemption of shares. The ability to regularly create and redeem shares meant that open-end funds could be bought or sold at NAV. At its inception, this feature was largely overlooked. However, with the onset of the Great Depression, closed-end funds began to trade at deep discounts to NAV and investors lost substantial sums. Conversely, investors in open-end funds were able to buy and sell at NAV throughout the Depression. As a result, the open-end structure increased in popularity and the closed-end fund structure was sidelined. Open-end mutual funds have subsequently proliferated to nearly every corner of the globe.
The innovations of both mutual funds and the open end structure were rooted in financial crises. Similarly, the exchange-traded fund structure has its roots in the stock market crash of 1987. Without going into too much detail, institutional investors discovered from the dynamics of this market crash that they had a need to trade large amounts of stock quickly, and preferably on an intraday basis. In 1990, one idea was postulated and acted upon by a Los Angeles-based investment firm Leland, O'Brien and Rubinstein (LOR) that stocks could be grouped together into a basket, placed on an exchange, and traded as a single unit. Essentially, they wanted to put a fund on an exchange. While LOR succeeded in creating this fund, labelled SuperTrust, it fizzled out after a couple of years due to lack of interest, which in part was owed to its high minimum investment requirements.
However, the idea of placing a fund on an exchange wasn't dead. In Canada, the Toronto Index Participation Shares tracking the Toronto Stock Exchange 35 (TSE 35) began trading on the Toronto Stock Exchange in 1990 and became very popular. On the heels of this product's success, the concept of an exchange-traded fund was revived in the US. Over the next few years, the concept wove its way through the regulatory channels and ended in 1993 with what many consider to be the first, modern representation of the exchange-traded fund in the US: Standard & Poor's Depositary Receipts (SPDRs) tracking the S&P 500 index. SPDRs, offered by State Street Global Advisors, were unique because of an arbitrage mechanism (to be described later) that allowed the fund to stay closely in-line with its NAV despite trading on an exchange. Perhaps more importantly, however, the SPDRs were cheap–-nearly anyone could buy them.
Therefore, exchange-traded funds were initially borne out of a need for greater liquidity--similar to the other innovations already discussed. However, that does not in and of itself explain why exchange-traded funds became popular investment vehicles. To understand this, we need to understand what had been happening in the mutual fund industry in the years leading up to this point.
At the start, mutual funds were created out of convenience because individual investors lacked the capital to construct well-diversified portfolios as well as the know-how to invest their capital. Mutual fund managers were given the task of not only safeguarding their assets, but realising a reasonable rate of return on the invested asset pool. As time wore on, however, mutual fund returns faced greater scrutiny.
During the 1970s, research published by Burton Malkiel and others showed that actively managed mutual funds, on average, failed to outperform their benchmark indices. In response to growing academic literature, Jack Bogle launched the first index mutual fund in the US in 1975. At first, Bogle's approach was ridiculed by the investment community with a large fund company exclaiming, "Who wants to be operated on by an average surgeon, be advised by an average lawyer, or be an average registered representative, or do anything no better or worse than average?"
However, the data didn't lie. Over time, the preponderance of actively managed mutual funds (most estimates place this at 2/3) tended to underperform their relevant benchmarks. For many investors, therefore, the emergence of index mutual funds shifted their focus from trying to outperform indices to trying to obtain the purest form of index performance. This came to be known as passive investing. As we shall see, exchange-traded products just happen to be extremely adept at executing passive strategies because of their structural design and became viewed as alternatives to index mutual funds. Over time and as a result, ETPs have proliferated in number and grown in assets alongside the growth in passive investment strategies.
This article was originally published February 2012.
