No overnight US success story
The huge success of exchange-traded funds comes as no surprise to the people who pioneered the product. But over the nine-year history of the portfolio tool, there have been times where many doubted ETFs would ever gain more than peripheral acceptance.
Paul Aaronson, now executive managing director of Standard & Poor’s Portfolio Services, recalls how on March 18, 1996, he and his team at Morgan Stanley sat glued to their screens. They were expecting to see high volumes of trade in WEBS – the new security they had created. After all, it was the first day of trading for this new breed of ETF.
“We were so convinced they would be successful,” he said. “But when trading opened, there were just one or two hundred on the screen – and most of it was from our own desk. It became clear there was a very significant education process.”
As with any new product, it took some time for people to realise what ETFs were, and how to use them, says Aaronson.
When the first ETFs were launched on the financial markets, they were not named as such. The term ETF was coined around four years ago. In the early 1990s, various prototypes came into existence – many of which are still popular products today. The earliest successful examples of the modern portfolio-traded-as-a-share structure were the TIPS and SPDRs. But the gradual evolution began before that.
In his book ‘The ETF Manual’, Gary Gastineau of US firm ETF Advisors says the idea originated with portfolio trading, or program trading. In the late 1970s and early 1980s, program trading was the completely new ability to trade a whole portfolio with a single order. Often that portfolio would consist of all the S&P 500 stocks, for example.
Out of this developed the demand for a readily tradeable portfolio or basket product, so that smaller institutions and individual investors could reap the benefits of program trading. It was on the back of this demand that Index Participation Shares or IPS were created. IPS were a simple and totally synthetic proxy for the S&P 500, though IPS on other indices were also available.
However, the ill-fated IPS were found by a federal court to be illegal futures contracts which had to be traded on a futures exchange if they were traded at all. So stock exchanges had to close down their IPS trading.
Next came TIPs – Toronto Stock Exchange Index Participations – a warehouse receipt-based instrument designed to track the TSE-35 index. Though they were successful, they turned out to be costly for the exchange.
Meanwhile, in the US, two other portfolio share products were being developed – Supershares and SPDRs. Supershares were produced by Leland, O’Brien, Rubenstein Associates. They were structured using both a trust and mutual fund structure. They were a high-cost product and their complexity made them confusing for many customers, Gastineau says. Supershares never traded actively and the trust was eventually liquidated.
The success of SPDRS, or Standard & Poor’s Depositary Receipts, on the American Stock Exchange ballooned in the late 1990s, though even in the early years, the funds had traded reasonably well, says Gastineau. Now, the S&P 500 SPDRs holds more assets than any other index fund except the Vanguard 500 mutual fund. SPDRs now account for more than a third of ETF assets in the US.
In 1996, WEBS, or World Equity Benchmark Shares, which were developed by Morgan Stanley and managed by Barclays Global Investors, were launched in the US. BGI later renamed them iShares MSCI Series. Following this, another significant ETF to be introduced was the DIAMONDS – based on the Dow Jones Industrial Average and run by State Street Bank.
Although State Street Global Advisors was involved with the creation of the earliest ETFs, StreetTRACKs is the firm’s first solo ETF product.
Following the launch of SPDRs and WEBS, notes Don Cassidy, senior research analyst at Lipper, there was a shift towards other domestic indices beyond the S&P. “Notable were a Dow Jones 30 – ticker DIA – and especially the QQQ (the ticker) for the Nasdaq 100, as in the late 1990s the latter market was roaring and it generated huge great public interest,” he says.
The QQQ was the ETF which put the product type well and truly on the map, says Aaronson. “It was heavily focussed on technology which was the sector of the time. The product really proved itself,” he says.
By this point, ETFs were being used for investment, hedging, shorting, and by independent small advisers as substitutes for index funds, says Cassidy.
The way ETFs are structured now has a lot to do with their original creator, Gastineau points out. When the SPDR – the original ETF – was developed at the American Stock Exchange, the prinicipal developer was Nathan Most, a man with a background in commodities. It was partly this background which led him to see the SPDR as a warehouse-receipted product.
His idea was that broker-dealers or investors would receive warehouse receipts – in the form of fund shares – in return for depositing baskets of stock with the trustee. Later on, if they decided they no longer wanted the fund shares, they could be exchanged for the underlying basket of securities.
Even though the first ETFs were created in 1993, it was not until 1999 that ETFs gained widespread acceptance. Rafts of new ETF products were launched in that year, notably by Barclays Global Investors and Vanguard. Until that point, John Bogle, founder of the Vanguard group, who was seen by many as the father of indexing, had said ETFs were instruments for day traders only. So when Bogle backed ETFs, launching VIPERS – Vanguard Index Participation Equity Receipts — it was seen by many as a move which legitimised them.
One factor which has been a stumbling block to the rapid increase in the numbers of ETFs on the market has been the regulatory framework. In the US, there are several provisions under the Investment Company Act of 1940 which are inconsistent with the way ETFs are operated.
Though legislators in the US have given the Securities and Exchange Commission authority to grant exemptions from the requirements of the act, exemptions are not granted automatically. Gastineau points out that the development and proliferation of ETFs has been significantly hampered by the process of getting exemptions for each issuer and each category of funds.
“It is reasonable to expect that the process will be streamlined somewhat in the months and years ahead,” he says, “but it is likely to be some time before a new issuer will be able to bring out a new ETF of a previously exempted type without an exemptive filing, and even longer before an established ETF issuer will be able to bring out a new type of ETF without specific exemptive relief from the commission.”
For most of the nine years they have existed, ETFs have been tools for large and institutional investors only. Gus Fleites, director of ETFs at State Street Global Advisors, says this focus has restrained the product’s potential. “Not enough attention had been put on the fact that it could be a very attractive retail product,” he says.
In Spring 2000, Barclays Global Investors announced its intention to launch a series of ETFs – iShares – onto the UK market.
Many European investors, says Deborah Fuhr, head of ETF research Europe and Asia at Morgan Stanley, had been using the US ETFs because of the way these instruments looked at funds as shares.
However, restrictions are in place preventing US investment products being marketed to retail investors outside the country. Commentators have put this state of affairs down to the protectionism which exists in both the US and Europe over their own financial products. In the case of large institutional investors, these hurdles can often be overcome by taking advantage of private placement exemptions, for example.
So there was a demand among European investors for US-style ETFs, but asset managers in Europe could not market these ETFs in Europe as they were currently structured. They did not comply with UCITS requirements. “ETFs were not UCITS-compliant, and that was one of the forces which drove them (asset managers) to develop ETFs (for the European market),” says Fuhr.
As exchange-listed and traded instruments, ETFs use a different form of distribution from investment funds. Like shares, they change hands through the exchange and broker system, which increases liquidity and cuts transaction complexity. Investors in Europe wanted to be able to capitalise on this smoother distribution.
Asset managers, too, saw the high degree of success and levels of turnover achieved for some of the most visible ETFs in the US, such as the QQQ, and wanted to repeat this in Europe. According to Morgan Stanley, ETF assets in the US grew to over $91.5bn at the end of August this year; Lehman Brothers estimated them at less than $10bn as recently as 1997.
In Europe, assets under management in ETFs swelled from $675m in early 2001 to over $8.7bn by the end of August this year, according to Morgan Stanley data.
And stock exchanges also saw ETFs potentially as massive revenue generators for them. “ETFs really saved the American Stock Exchange,” says Fuhr. “It was floundering in terms of volumes,” before the advent of this new investment product.
The growth in passive or index investment has been another factor behind the rise of the ETF both in the US and Europe.
“ETFs are a natural vehicle to get passive exposure,” says Fuhr.
Developments in the ETF marketplace continue apace. Just a few months ago, the SEC gave its approval for bond-index-based ETFs, and about $4bn was quickly raised, says Cassidy. “We still await SEC action on the pending proposals for ETF classes of actively managed funds,” he says.