Illustration by II
“To be ignorant of what occurred before you were born is to remain always a child. For what is the worth of human life, unless it is woven into the life of our ancestors by the records of history?”
—Cicero
The investment industry is abuzz with the anticipated approval of several bitcoin exchange-traded funds. According to one source, the approval of these ETFs will foster “a more inclusive global financial landscape. These developments signal a new era in cryptocurrency, one where bitcoin's potential is unlocked for a diverse range of investors and its role in international economic empowerment is further solidified.”
Maybe. But this so-called new era is entirely dependent upon a specific historical event that occurred more than 30 years ago on January 29, 1993, when the American Stock Exchange partnered with State Street Bank and Trust Co. to list the first ETF, the Standard & Poor’s Depositary Receipt — also known as the Spider based on its acronym, SPDR.
The Spider, designed to track the S&P 500, started a revolution in the global asset management industry, one that democratized investing by allowing investors to buy and sell a low-cost, diversified portfolio just like a share of stock. In the process, the fund spawned its own global financial ecosystem, of which bitcoin ETFs are simply the newest organism.
Today, about 160 issuers offer more than 10,000 ETFs tracking the performance of industries, sectors, commodities, geographies, and other financial niches, and which represent almost $10 trillion. By comparison, there are only about 5,000 stocks. In fact, ETFs now account for about a third of all stock trading in the U.S., about one-seventh in Europe, and one-tenth in Asia, according to a BlackRock report. The ETF spigot remains fully open, with more than 50 new ETFs launched in the U.S. in October alone — or about two each day.
In November 2001, the Cboe launched options on the Spider, which have been broadly adopted by investors. As of September, volume for 2023 was almost $100 trillion.
In 2006, leveraged ETFs were added to the ecosystem, with inverse ETFs and actively managed ETFs coming two years later.
It was interesting timing. According to Bank of New York Mellon, Bear Stearns launched the first active ETF just one day after JPMorgan Chase & Co. upped its fire-sale bid to buy the beleaguered investment firm.
Despite such an inauspicious beginning, fund managers were quick to see the benefits of wrapping an actively managed strategy in an ETF. And today, there are about 1,240 active U.S. ETFs, representing $448 billion in assets.
ETFs have transformed the mutual fund industry. According to Morningstar, in 2022, “global open-end funds had $1.28 trillion in outflows, while ETFs had $754 billion in inflows.” ETFs have prompted more and more fund companies to launch ETFs instead of mutual funds, and other firms, including Dimensional Fund Advisors and J.P. Morgan Asset Management, have converted their existing mutual funds into ETFs.
ETFs, a retail phenomenon, are poised to shake up institutional asset management. Institutions increasingly are choosing ETFs over separate accounts. The Financial Times reported that “74 per cent of US asset managers viewed ETFs as a large opportunity compared with 70 per cent for institutional SMAs used by entities such as foundations, endowments, and insurance general accounts.”
Many argue that ETFs are the last example of innovation in asset management, an industry not known for breakthroughs. A look back at the genesis of ETFs, which can be traced to a confluence of historical phenomena, provides some clues to what made the Spider’s 1993 launch possible and paved the way for its future success.
A group of analysts and portfolio managers, including academics-cum-investment professionals Jack Treynor and Bill Sharpe, used these tools and early computer power to gauge the value of traditional security analysis and portfolio construction. The esteemed group famously concluded that this approach could not be used to create a portfolio of securities that would consistently outperform the market.
The traditional approach was, in the words of the O.G. quant, Bill Fouse, “intellectually bankrupt.”
Fouse wrote that “both clients and practitioners generally recognize that conventional practice has failed to meet their expectations. Fortunately, a powerful ‘new’ conceptual foundation exists upon which practitioners can rebuild their approach to both security analysis and portfolio management.”
This strategy, justified by Fama’s efficient market hypothesis, did not try to beat the market at all, but instead mirrored the entire market: the index fund.
At Wells Fargo, John "Mac" McQuown, David Booth, and Fouse were in talks with the Samsonite pension fund about this new approach and, in 1971, launched the first index fund. The fund was based on an equally weighted New York Stock Exchange index, which proved to be operationally challenging. But in October 1973, they offered a fund based on the capitalization-weighted S&P 500 index. The Illinois Bell System pension became the anchor investor.
That year, American National Bank & Trust Co. also launched an S&P 500 index fund, based on a technique developed by Rex Sinquefield called stratified sampling. The New York Telephone Co. pension fund was the first client. (Other managers had considered launching index funds, but few clients were interested.) In 1973, Burton Malkiel published A Random Walk Down Wall Street, in which he presented Fama’s efficient market hypothesis to the public. By mid-1975, American National declared that indexing would be its primary approach to investing.
(History lesson: In 1996, Wells Fargo sold its indexing business to Barclays Bank of London, which operated it under the name Barclays Global Investors (BGI). BlackRock acquired BGI in 2009. Sinquefield and Booth founded Dimensional Fund Advisors in 1981.)
American National’s timing was prescient: As late as 1973, national and regional trust banks, not specialized asset management firms, still managed the vast majority of institutional assets, primarily in balanced accounts that were often a combination of actively managed large-cap U.S. growth stocks (especially the so-called Nifty 50) and fixed income.
In 1973, the bear market hit, and by the end of the year, the S&P 500 was down 14.7 percent. A year later, the index lost another 26 percent. Bank trust departments, which were overallocated to these large growth stocks, generally held their positions as they declined in price.
Only two banks managed to beat the S&P 500 in 1973: Bank of New York, which was down 11.2 percent, and Philadelphia's Girard Bank, which declined 14.1 percent. J.P. Morgan, Chase Manhattan Bank, and Bankers Trust were down 20.8 percent, 17.9 percent, and 28.4 percent, respectively.
But he backlash to index funds came quickly, which is understandable because, as Nataliya Nedzhvetskaya, a sociologist at the University of California, Berkeley, correctly observes, index funds “threatened not only the dominant logic of the industry but also the livelihoods of well-compensated investment managers and the profits of multi-billion dollar firms.” However, such barriers didn’t stop money from flowing into these Ur-index funds.
Other asset managers soon began offering competing products, with Jack Bogle’s Vanguard launching the first equity index mutual fund, now the Vanguard 500 Index Fund, followed in 1977 by the first indexed bond funds. Incumbents, sensing a sea change, adapted their businesses to seize market share.
Investors’ acceptance of index funds continued to grow, and by 2022, 45 percent of all assets managed by investment companies in the U.S. were in passively managed funds.
The Securities and Exchange Commission’s postmortem report on the crash suggested several remedies intended to reduce the possibility of future cataclysmic market breaks, including the idea of creating a single security representing the entire market.
“One of several alternatives that may be worthy of examination is the proposal to create one NYSE specialist post where the actual market basket could be traded,” the SEC wrote in its report. “A market basket post would alter the dynamics of program trading, in effect consolidating program trading back to a single order. The index specialist would have the informational advantage, not available to specialists in the individual stocks, of seeing the entire program order. Moreover, focusing institutional program trading at a single post might encourage additional block positioning activities, thereby potentially increasing the liquidity on the NYSE floor.”
Even with this SEC tailwind, firms faced considerable obstacles in designing and implementing such a broad market security. Several firms and exchanges tried to launch various basket products, such as index participation shares in 1989, but failed because of regulatory barriers and design flaws.
In the end, it was not the NYSE or a large asset manager but the Amex that came up with a way to overcome these obstacles.
To ensure I present the Amex’s experience accurately, I spoke with a long-time friend, Cliff Weber, who — along with the late Nate Most, Steven Bloom, Ivers Riley, Joe Stefanelli, and Jay Baker — was part of the Amex team that designed and developed SPY, the ticker symbol for the ETF. I met Weber and his colleagues when they were developing SPY during my tenure as an exchange official at the Chicago Mercantile Exchange.
Weber told me that Most and Bloom came up with the idea for the ETF, in part building on Most's experience trading palm oil receipts. Physical commodities like palm oil are stored in a warehouse, with traders exchanging receipts verifying their ownership of a certain amount of the commodity. Most and Bloom extended this idea by envisioning a virtual warehouse that stored physical securities. According to State Street, shares of an ETF “would represent a direct claim on securities effectively ‘warehoused’ in a unit investment trust.”
Weber recalled that transforming this idea into a tradable security presented the group with four principal challenges.
First, the unique ETF structure presented novel regulatory issues. The Amex turned to the lawyers at Orrick Herrington & Sutcliffe LLP for help petitioning the SEC for relief from various provisions of the Investment Company Act of 1940, the Securities Act of 1933, and the Securities Exchange Act of 1934. (The lawyer responsible for leading the regulatory effort, Kathleen Moriarty, became known as “Spider Woman” because of her pioneering work in this area.)
Because of the effective arbitrage mechanism embedded in the ETF structure, the team was able to convince the SEC that the SPDR shares would trade very close to their underlying fair value throughout the trading day, ensuring that retail investors trading on the exchanges would not be disadvantaged relative to the institutions creating and redeeming shares directly with the ETF at net asset value.
Second, the Amex, an exchange, had no expertise or capability in funds. The Amex partnered with State Street Corp. because of State Street Global Advisors’ expertise in portfolio management and State Street Bank and Trust’s capabilities in custody, administration, and operations. State Street's insights were invaluable in developing and refining many of the operational aspects of the product.
Third, ETFs presented significant operational challenges that needed to be overcome. The clearance and settlement system had to be enhanced to facilitate the creation-redemption process. The Amex and State Street worked with the National Securities Clearing Corp. (NSCC), which guarantees trades for buyers and sellers in U.S. markets, and the Depository Trust Co. (DTC), the central depository for U.S. securities, to develop an automated mechanism for converting institutions’ creation-redemption orders into instructions to exchange with the SPDR S&P 500 ETF Trust’s 500 individual positions in the underlying securities for shares of the SPDR. Additionally, the NSCC developed an automated mechanism for distributing the information the institutions needed to price and trade the shares in the secondary market efficiently. (The NSCC and the DTC later merged to form the Depository Trust and Clearing Corp.)
With SPY being an entirely new type of security, Bloom and Baker needed to educate the investment community about its benefits and uses and attract trading. According to Bloom, “We couldn’t get anybody to sell it. Nobody was compensated, so we had to walk everyone through it.” Baker cold-called anyone who might listen to him, while Bloom fielded any product questions the institutions could throw at him.
As Weber made clear, the Amex had strong motives for creating an ETF at the time. The Amex was losing the new and lucrative listing battle to the NYSE and the Nasdaq. With SPY, the Amex could create and list its own securities and earn the associated fees, effectively controlling its own destiny. (The NYSE acquired the Amex in 2008.)
The team’s five-year effort was successful: Rejecting incrementalism, the team outflanked larger, better-resourced competitors and created a multipurpose instrument that revolutionized the global investment industry.
Yet the genesis of the team’s success can be traced back over 50 years to the groundbreaking academic ideas that set the stage for index funds. Investors eagerly adopted index funds after several market dislocations revealed the need to transform this idea into marketable securities, of which SPY was the first. This throughline continues today, with the expected SEC approval of bitcoin ETFs.
Beyond being a simple history lesson, the context around ETFs provides a possible template for innovation that our industry so desperately needs.
Angelo Calvello, Ph.D., is co-founder of Rosetta Analytics, an investment manager that uses deep reinforcement learning to build and manage investment strategies for institutional investors.
