The ETF Files

How the U.S. government inadvertently launched a $3 trillion industry.

The 840-page report from the U.S. Securities and Exchange Commission contained an unexpected present.

It arrived on Nathan Most’s desk at the American Stock Exchange in February 1988. Four months earlier, on Oct. 19, Wall Street had collectively gasped as the Dow Jones industrial average plummeted 508 points, or 22 percent. Black Monday, as the rout became known, remains the biggest one-day crash in history, and this 5-pound white paper, titled The October 1987 Market Break, was the SEC’s postmortem on the event.

The report couldn’t have found a more receptive audience. Most, a pragmatic 74-year-old industry veteran, was vice president of new product development at AMEX, a once-dominant exchange that had settled behind the New York Stock Exchange and Nasdaq in equity trading. By the late 1980s, only a handful of Standard & Poor’s 500-stock index companies even listed on the AMEX, Hasbro Toys and Forest Laboratories among them. “We were not really first in anything,” says Steven Bloom, who’d recently graduated from Harvard University with a Ph.D. in economics and worked alongside Most. In Black Monday’s wake, AMEX Chairman Arthur Levitt needed Most and Bloom, his two-person product development team, to come up with a winner that could attract institutional investors and help the exchange remain relevant.

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Cover artwork: Kelsey Henderson

Most and Bloom read the entire report within a few days, gaining new insight into the causes of the crash as well as what exacerbated the selling. “I found every page riveting,” says Bloom, who’s now a professor of economics for the Dwight D. Eisenhower School at National Defense University. The culprits, the report noted, were portfolio insurance and program trading. Many institutional investors had started using portfolio insurance—a strategy that involved selling stock index futures once the market had declined by a specified percentage, allowing them to hedge the large amount of stocks they had accumulated. When stocks started to decline on Black Monday, institutions went to sell those futures, only to discover that the sudden rush of sellers vastly overwhelmed those willing to buy. This forced the futures to trade at discounts to the stocks they represented, triggering program traders to enter the market with automated sell orders for stocks underlying the index futures. Chaos ensued. The selling and volatility in the futures market had, in essence, been transmitted to individual stocks, increasing the panic and exacerbating the selloff.

One particular section of Chapter 3 caught Bloom’s attention. There, the SEC suggested that “an alternative approach be examined” and posited that if well-capitalized specialists and supplementary market makers could have turned to a single “product” for trading baskets of stocks, the market damage—and volatility—may have been significantly smaller. Indeed, such a product might even have prevented the crash by providing a liquidity buffer between the futures market and individual stocks. “I walked into Nate’s office and said, ‘Here’s an opening we could drive a truck through,’ ” Bloom says.

Of course, today we do have what the report refers to as basket-trading products. We call them exchange-traded funds, or ETFs, and they’re a $3 trillion global industry, with more than 6,780 products on 60 exchanges to choose from. In the U.S. last year, ETFs traded about $20 trillion worth of shares—more than the country’s gross domestic product. ETFs allow people to invest in every asset class they can think of, and their tickers range from TAN, which tracks solar stocks, to SVXY, which provides inverse exposure to VIX futures.

But for all their charm, ETFs are an increasing concern to regulators. On Monday, Aug. 24, for instance, the S&P 500 fell as much as 5.3 percent in the opening minutes of trading. It was the market’s worst day in four years. #BlackMonday started trending on Twitter. Of the 1,278 securities halted for trading, 80 percent involved ETFs, according to the SEC. On a typical day, ETFs make up about 25 percent of equity trading volume. That day, they made up almost 40 percent. In the months since, the SEC has published a research note about the day’s volatility, proposed new rules to enhance liquidity and limit derivatives in certain ETFs, and indicated that additional oversight may benefit the financial industry. SEC Chair Mary Jo White has said the agency is “very focused on ETFs.”

Yet, as Most and Bloom were discovering at AMEX in 1988, the SEC had essentially requested the ETF’s very creation. “The theory presented was that it would be possible to create baskets of key stocks available for sale,” says David Ruder, a professor of law at Northwestern University who was SEC chairman from 1987 to 1989. “Those baskets would then be able to be sold without causing the whole market to collapse.” It was just a suggestion, Ruder says, and one the SEC didn’t expect anybody to act on. Bloom remembers another detail he and Most latched onto: He recalls the SEC indicating that if someone wanted to engineer such a product, the agency might grant approval quickly.

The AMEX team dropped everything else and dove in. “We were essentially reverse-engineering what the SEC called for in their report,” Bloom says. “We viewed it as a product proposal being made by the regulators.”

One of their earliest ideas was to see if index mutual funds, as they existed, could be traded. At the top of Most’s list of people to meet with was none other than John “Jack” Bogle, who was pioneering low-cost indexing as the founder and chief executive officer of Vanguard in Valley Forge, Pa. “Nate walked into my office when I was running this place,” says Bogle, 86. “He said he wanted us to partner, to use our S&P 500 index fund.” Bogle told him his idea had several flaws, and “even if you fix them, I’m still not interested.”

Bogle doesn’t recall the specifics of his criticisms (“I’m 111 years old after all!”), but he does remember the general thrust: He didn’t like the idea of investors coming in and out of his fund, because it would substantially increase operating costs. “The idea of trading all day long in real-time is just anathema to me,” he says. “I just didn’t want to do it.”

Most would later tell MarketWatch the meeting with Bogle got him “thinking about a product where you don’t go in and out of the fund.” (Most died in 2004 at age 90.) He and Bloom wanted a way that people could trade a fund throughout the day without driving up costs—something that would distinguish the fund’s operation from exchange trading.

“I found every page riveting,” says Bloom—especially this one, which inspired him to help create what would become the world’s most-traded security

Most, who studied physics at the University of California at Los Angeles before serving as a Navy submarine engineer during World War II, ultimately found inspiration from his time in commodities—first as a trader for Pacific Vegetable Oil, then as president of the Pacific Commodities Exchange. As Most knew, commodities are typically stored in warehouses, which issue ­receipts that can then be traded. “You store a commodity and you get a warehouse receipt,” Most later recounted for founder Jim Wiandt. “You can sell it; do a lot of things with it. Because you don’t want to be moving the merchandise back and forth all the time, so you keep it in place and you simply transfer the warehouse receipt.”

He and Bloom wondered why that same concept couldn’t be applied to a basket of equities. You could have a specific group of stocks handed to a custodian in return for shares. Those shares could then be broken up and sold on an exchange. You could also buy shares on the exchange and then hand them to the warehouse and get your basket of stocks back. Such an arrangement would allow people to trade their shares as much as they wanted while not disturbing the securities in the custodian’s electronic warehouse or racking up trading costs for the fund’s investors. “The ‘in-kind’ creation/redemption process was to deal with Bogle’s concerns and with the transactional drag,” says Kathleen Moriarty, a partner at Kaye Scholer who provided legal assistance to AMEX at the time. “It also reduced costs by as much as 50 basis points.” Another big win: The structure enabled significant tax benefits. Because no money exchanges hands when shares are created and redeemed, the product would not emit capital gains distributions the way mutual funds do—“a wonderful side effect,” Moriarty says.

Most and Bloom’s idea required a virtual warehouse to store the stocks, so they teamed with State Street as a trustee and custody agent. They also needed an index to track and settled on the S&P 500, the one most widely followed by institutional investors.

SEC approval would prove more difficult than expected. Most and Bloom wanted the product’s holdings to reflect changes each day to the index, and their lawyers told them that was technically “engaging in the managing of a fund,” which necessitated filing under the Investment Company Act of 1940 as a Unit Investment Trust. Doing so meant they’d receive the heaviest of scrutiny from the SEC. While expedited approval went out the window, this decision would prove key in the ETF becoming at once a volume generator as well as an asset gatherer, and a hit among retail investors.

Bloom and Most filed their application with the SEC in 1989. Howard Kramer, a staffer in the SEC’s Division of Market Regulation who had helped draft portions of The October 1987 Market Break, remembers the filing well. He quickly realized that Most and Bloom had elevated the agency’s raw concept into something entirely new and different. “When we wrote the Market Break report, we were thinking in very general terms to help with market volatility,” says Kramer, now a partner at Willkie Farr & Gallagher. “But the type of product the AMEX came back with had a utility that went way beyond this.”

Others at the SEC, however, were more skeptical about letting what looked like a mutual fund trade on a stock exchange. “I had the chore of not only analyzing the proposal but getting it through the commission approval process,” Kramer says. Sensing this would become a revolutionary product class that would benefit retail investors, Kramer says he lobbied for the proposal at every stage of what became a four-year-long approval process. “If Nate and Steve were the parents of this product,” he says, “I was one of the midwives.”

Most and Bloom weren’t the only people inventing financial instruments in the late ’80s. As they awaited regulatory approval, Bloom says he and Most mentioned their product to a team from the Toronto Stock Exchange. The Canadians, who’d also been studying a variety of index-tracking derivatives, liked what they heard. Unimpeded by the regulatory molasses in Washington, they managed to get their version of a market-basket product—which tracked the Toronto Stock Exchange 35 Index—approved within a year. The Toronto Index Participation Shares, or TIPS, made its debut in 1990. “The idea was hatched in the U.S. but was launched in Canada first,” says Peter Haynes, a managing director at TD Securities who worked at the Toronto Stock Exchange then.

The SEC finally approved AMEX’s market-basket product in January 1993. Most and Bloom decided to name their brainchild the Standard & Poor’s Depositary Receipts, or SPDRs. After all, just like that commodities warehouse, these were “receipts” based on a “deposit.” They gave it the ticker SPY and an expense ratio of 0.20 percent—exactly the same as the 0.20 percent expense ratio of the Vanguard 500 Index Fund, which already had $6.5 billion in assets. 

SPY’s launch fanfare included a 9-foot-tall inflatable spider dangling from AMEX’s ceiling at 86 Trinity Place. The ETF traded a million shares the first day—a reasonable success. But the novelty and hype soon subsided, and SPY began to trade less and less. By mid-June, volume had shrunk to 18,000 shares. Even James Ross, global head of State Street’s ETF business, who took the call for the creation of the first shares, began to have doubts—especially when assets under management slipped from $461 million in 1994 to $419 million in 1995. “That was when there was the question of, Is this thing ever going to work?” he says.

One of the biggest hurdles was that no one was compensated to sell SPY. To this day, the lack of sales charges offered by the ETF to brokers is at once a tailwind and a headwind to its growth. Investors love the fact that they don’t need to pay a broker to buy an ETF; brokers hate it for the same reason.

SPY eventually caught on the way many successful products do, with true believers spreading the word. Gary Eisenreich, a specialist at Spear, Leeds & Kellogg tasked with providing liquidity as the product’s first market maker, was among them. “I looked at SPDRs as a thing I could sell my grandmother,” says Eisenreich, who’s now a managing partner at Fairfield Advisors. An eventual pickup in the stock market also helped SPY go meteoric. By 1998 the ETF had gained 160 percent and had $12 billion in assets. It never looked back.

How ETF Shares Are Created and Redeemed

ETFs contain an assortment of securities. Think of them as a basket. ETFs track indexes; for instance, SPY, the world’s most-traded security, follows the S&P 500. Others follow indexes made up everything from tech stocks to municipal bonds. New ETF shares are created and redeemed by trading the basket for the ETF and vice versa.

Imagine the stocks below are the ones in the ETF’s basket. The ones on the left have many shares on the market; the ones on right have the fewest.

Now, say you’re a large bank. If you give the ETF a bit of each stock in the basket, the ETF will hold the stock shares and give you a share of the whole fund. The more you do this, the more the fund grows. Try it:

This is good for the fund, because it keeps a tiny bit for itself. And it is good for you, the bank; so long as there is demand, you can sell the bits of the basket for more than you bought the bits of stock.

The ability to create and redeem shares creates a economic incentive for big investors and market makers to arbitrage the price of the ETF with the fair value of the stocks in the basket. This continuous arbitrage is why an ETF’s price on the exchange is typically very close to the value of the securities in the basket. This is crucial for investors who like to know they are getting a fair deal when trading.

Now, the values of the stocks in the basket constantly vary, which means the value of the basket also varies. But when shares of the basket are trading freely on the market, the price of a share of the basket won't quite stay in sync with the true value of what it stands for.

This is an opportunity for you, the bank—a balancing act, if you will. If the ETF’s price is above its value, you can make money by adding more bits of stock to the fund: buy the stocks for the cheaper price, sell the ETF for the higher price. And you can also do the opposite: if the ETF’s price is below its value, you can return shares of the ETF in exchange for the stocks it stands for, which you can sell for more.

We can imagine the weight of the bits of stock the fund owns balancing atop the fulcrum at the ETF’s market price. They roll right as their price goes up, and left as their price goes down. Try to keep the price of the ETF balanced near its value by creating and redeeming shares:

So you get paid to get things more balanced—the difference is your prize money. This makes the ETF more useful and reliable to everyone. Congratulations, you’re a market-maker arbitrageur!

Today, SPY is the world’s most-traded security. On average, SPY trades $25 billion worth of shares each day, or $6 trillion a year—four times as much as Apple, the second-most traded security. In fact, SPY trades as much as the 24 most-traded stocks combined. It also accounts for about $50 billion worth of options volume each day, which is almost 50 percent of the entire equity options market. SPY also happens to be the largest ETF, with $166 billion in assets, as of Feb. 8.

For AMEX, SPY proved an unqualified commercial success. Most said in 2000 that ETFs “pretty near” rescued the exchange, “but they don’t like to admit it.” As far as the solution the SEC was envisioning, Most and Bloom seem to have checked that box as well. ETFs have taken pressure off individual stocks. On any given day, the vast majority of ETF trading happens in the secondary market and doesn’t involve creations and redemptions using the underlying securities, which definitely qualifies as a liquidity buffer.

Another fascinating aspect of ETFs is that they’re at once a replacement for a mutual fund, hedge fund, or a separately managed account, as well as a tool used by them. While institutions were the first users of ETFs, much of the recent growth has come from advisers and retail investors—so much so that ETFs’ assets are roughly split between institutional and retail. In other words, ETFs may have accomplished something more unexpected than saving AMEX or providing a liquidity buffer. You can almost say they’ve democratized investing. The little guy is accessing the very same markets—for the same cost—as the big guys.

But ETFs have grown far beyond what the SEC could have imagined, particularly their expansion into asset classes such as fixed income and commodities. “I don’t think we envisioned at the time we wrote the report that the use of baskets would be widespread,” says Ruder, the former SEC head. “I think we saw the baskets as a way to provide relief to the volatility problems we were facing. Additionally, the kind of baskets we were talking about were not baskets containing nonstocks.”

Everyone involved in those early days—even Bogle—knew the ETF had a shot at success. That the same SEC that helped spark the idea as a solution to lessen volatility in the markets would one day worry that ETFs could be a threat to the markets is rather remarkable. Indeed, the investment vehicle’s success amazes Bloom most of all.

“It started out as a product, and it became an industry,” he says.

Balchunas is an ETF analyst at Bloomberg in Princeton, N.J. Adapted from The Institutional ETF Toolbox (Wiley, 2016).

“Nate Most was one of the most creative guys,” says Levitt, who later served as SEC chairman from 1993 to 2001 and is a director of Bloomberg LP, parent of Bloomberg News. “We wanted to give him every resource possible to make the exchange more competitive.”
In early January the SEC’s Office of Compliance Inspections and Examinations announced it would include ETFs in a short list of “examination priorities” for 2016.
Bogle remains a persistent critic of ETFs. He has called them “the greatest marketing innovation of the 21st century” and likens them to “handing an arsonist a match” because they tempt investors to trade too much.
From Black Monday in October until Market Break was published in February, Kramer says he and his SEC colleagues working on the report only took off Thanksgiving and Christmas. “I remember thinking, I’m working for the government seven days a week?” he says.
TIPS never gained as much traction as SPY and became part of the iShares S&P/TSX 60 Index in 2000.
The term “ETF” didn’t originate until well after SPY was trading. According to Gary Eisenreich, its first market maker, Most coined it while working with Robert Tull at Morgan Stanley on a product called World Equity Benchmark Shares, or WEBS, in 1994. WEBS later became iShares, which BlackRock, the world’s largest ETF issuer, brought under its banner in 2009.
NYSE Euronext acquired AMEX in 2008 and moved the trading floor from 86 Trinity Place to NYSE at 11 Wall Street.
Most retired from AMEX in 1996, just as SPY began its ascent. He later took a position with Barclays Global Investors in the fledgling iShares Trust division.
Vanguard didn’t begin offering ETFs until 2001, after Bogle was no longer CEO or chairman, and already has more ETF assets than any firm but iShares.
Bloom entered academia in 2010, teaching economics at the United States Military Academy at West Point until 2016, when he joined National Defense University. He says he’s enjoyed watching the growth of ETFs from afar.