Introduction
The quite laborious beginning of what many consider to be the first exchange-traded fund (ETF) belies the strong growth and market acceptance that ETFs have enjoyed since the turn of the millennium. After that first ETF finally took off in the late 1990s, it shepherded the rise of a new concept in indexing that is enjoying remarkable success to this day. ETFs have finally become a mainstream investment tool both for individual and for institutional investors.
In order to appreciate the incredible ascent of this new investment strategy, it’s necessary to go over, with some level of detail, what was, what is, and what might be the life of these relatively new products used by an increasing number of swayed investors. The goal of this chapter is to do just that by reporting on what seem to be constant transformations by a product that keeps reinventing itself, especially since 2005, to keep the interest of those it has already won over alive and, at the same time, continue to make more converts.
Brief Background History of ETFs
The first ETFs were equity-based, but today ETFs are much more nuanced and encompass other asset categories. Their forerunners, at the risk of aggravating Canadian friends and colleagues who genuinely believe that their country is the true birthplace of ETFs, were the equity baskets that briefly traded simultaneously in Philadelphia and New York. Because their mechanics eerily resembled those of ETFs as we know them today, it’s very conceivable that they could have eventually morphed into the first actual ETF, traded in the United States and not in Canada, if it wasn’t for the controversy they stirred in their short three months of existence that led to their quick disappearance.
Equity Index Participations
These novel products began trading in May 1989 on the American Stock Exchange as Equity Index Participations (EIPs) and on the Philadelphia Stock Exchange as Cash Index Participations (CIPs). Although the available Index Participations were based on a variety of indexes, those based on the S&P 500 were the most active. They gave investors a position in each of the 500 stocks in the same proportion they were held in the index. They were priced at one-tenth the level of the S&P 500 index by market cap, and traded in lots of 100. Their small denominations made these contracts readily accessible to individual investors. Investors could take profits or losses in cash based on the overall performance of the index.
Although these products did not achieve the resounding success expected by those who came up with the idea, they certainly stirred plenty of controversy in their short existence, including a turf war with the Securities and Exchange Commission (SEC) and futures-industry officials. Indeed, because investors were presented with quarterly opportunities to close out their positions without actually owning the underlying stocks, both the Chicago Board Options Exchange and the Chicago Mercantile Exchange argued that these new products were, in fact, futures products rather than plain vanilla securities, and should have been under their jurisdiction. Although these products presented their holders with the same margin requirements as stocks, rather than the greater margins allowed for futures, in August 1989, shortly after their launch, the Chicago Court of Appeals sided against stock-exchange trading by index participations. It ruled that the SEC should not have approved the products in the first place.
Stung by this decision, the American and Philadelphia stock exchanges were forced to discontinue trading in index participation shares. In light of their relatively modest trading volume before the ruling, these index products never really had time to take off. Indeed, during the limited period over which EIPs/CIPs were traded, experts were debating (if not openly expressing skepticism) whether they could work on stock exchanges, especially as the market was (and is) subject to wild swings, such as had been experienced two years earlier in October 1987.
Toronto Stock Exchange Index Participations
In 2015, Canadians celebrated the 25th anniversary of the Toronto 35 Index Participation units, alternatively referred to as the TIPS or TIPS35, a fund that they, along with some ETF historians, consider to be the first ETF. The TIPS made its debut on the Toronto Stock Exchange on March 9, 1990. These warehouse receipt-based instruments allowed investors to participate in the performance of the TSX 35 index without having to purchase the individual shares of its constituent companies.
As with the defunct equity index participations traded in Philadelphia and New York, the 35 stocks were held in the trust in the same proportion as in the index, and similarly were priced at one-tenth the value of the underlying index. March 9, 1990 is indeed an important date in the history of ETFs, although at times it’s conveniently forgotten by those of us who believe it was the Standard & Poor’s 500 Trust Series 1 (SPDR S&P 500, ticker symbol: SPY) that started it all when it made its January 22, 1993 debut on the American Stock Exchange—almost three years after the TIPS, Canadians like to remind us.
The Toronto 100 Index Participation Units, or TIPS 100, followed soon after. They were linked to the largest 100 companies on the exchange. Both TIPS 35 and TIPS 100 had a management expense ratio of 0.05%, reflecting the fact that they were passive investments. This compared with an expense ratio of 2.19% for the average Canadian equity mutual fund at the time. Next, the Toronto Stock Exchange merged the TIPS 35 and TIPS 100 into the iUnits S&P/TSE 60 Index Participation Fund (2000) then changed its name to iUnits CDN S&P/TSX 60 Index Fund (2006), which the fund is still known as today.
The fund is known for its few capital gains distributions, meaningfully reducing its investors’ exposure to taxes. Shares are sold only to reflect changes in the index. It is also far more liquid than other funds, since shares can be traded anytime during market hours, while other funds must be bought and sold at the day’s closing net asset value. These traits, perceived as favorable by investors, have made the products widely popular both in Canada and internationally. Because these Canadian products undeniably have more characteristics of ETFs than the defunct basket products traded in the New York and Philadelphia Stock Exchanges in 1989, it’s not surprising that the country where they made their debut is considered by many as the true birthplace of ETFs.
U.S. ETF Market
As already noted, ETFs were launched in the U.S. markets in 1993, with the introduction of the Standard & Poor’s 500 Trust Series 1 (SPDR 500, ticker symbol: SPY).1 Sponsored by State Street Global Investors (SSgA), the SPDR 500 tracks the S&P 500 index, a widely followed index of market behavior.
From a Trickle to a Mighty Roar
The stock market effervescence of the 1990s was seen as the ideal environment in which to introduce a new financial vehicle to investors seeking new investment products. After all, who would not be interested in investing in a financial instrument that tracks a basket of stocks like a mutual fund but is not constrained by the trading inflexibility of the latter, since it is priced throughout the day like stocks? Moreover, unlike a mutual fund, an ETF is sold in affordable denominations; but like an index fund, it offers a diversified portfolio, expense structure, and greater tax efficiency, characteristics discussed in detail in Chap. 2 and other places in this book.
Despite positive reactions to the concept, the initial reception of ETFs was disappointingly lukewarm. Net assets under management after their first year of operation were well below expectations, totaling less than half a billion dollars, as shown in Table 1.1. The following year was hardly better. In fact, ETFs lost ground in terms of both total net assets and net issuance, as the value of all ETF shares redeemed exceeded that of shares issued by $28 million in 1994.
Table 1.1
U.S. ETFs by net assets,a net issuance of shares, and number of funds
Total net assets | Net issuance | Number of funds | |
|---|---|---|---|
Year | $ billion-year-end | $ billion-year-end | (end of period) |
1993 | 0.5 | 0.4 | 1 |
1994 | 0.5 | −0.28 | 1 |
1995 | 1 | 0.4 | 2 |
1996 | 2 | 0.8 | 19 |
1997 | 7 | 3 | 19 |
1998 | 16 | 6 | 29 |
1999 | 34 | 12 | 30 |
2000 | 66 | 42 | 83 |
2001 | 83 | 31 | 102 |
2002 | 102 | 45 | 113 |
2003 | 151 | 16 | 119 |
2004 | 228 | 56 | 152 |
2005 | 301 | 57 | 204 |
2006 | 423 | 74 | 359 |
2007 | 608 | 151 | 629 |
2008 | 531 | 177 | 743 |
2009 | 777 | 116 | 820 |
2010 | 992 | 118 | 950 |
2011 | 1,048 | 118 | 1,166 |
2012 | 1,337 | 185 | 1,239 |
2013 | 1,675 | 180 | 1,332 |
2014 | 1,974 | 50 | 1,411 |
Jan-... |