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  • #9 ETF: The Most Important Story of Financial Innovation You've Likely Never Heard Of - Pt 1

#9 ETF: The Most Important Story of Financial Innovation You've Likely Never Heard Of - Pt 1

How an Institutional Trading Product Become a Multi-Trillion Dollar Financial Force

Author

Ginger Professor
January 28, 2024

TLDR

A fair warning, this one is a bit longer but for good reason… the story is AWESOME. That’s why I’ve broken it up into two parts. 

I’m very invested in it.

The Whole Lesson

In the late 1980s, the world was reeling. “The first contemporary global financial crisis” was reverberating through markets following the Black Monday meltdown. On October 19 1987, the DOW dove 22.6% in a single trading session.

 It looked like this: 

I’m not going to go into why that happened, but those events eventually led to the birth of a multi trillion dollar industry and one of the most revolutionary (and important) financial products ever. 

If you care about becoming financially independent one day, Black Monday matters to you. Why? Because Black Monday led to the creation of the ETF (Exchange Traded Fund), which is one of the most popular and efficient tools for building long term wealth. 

The crazy thing about the ETF story though, is how much of it was a result of a few key events, absolute luck, timing and persistence (mixed in with a genuinely good idea of course). It’s a 33 year old (and counting), multi trillion dollar success story that could have never happened if not for one person picking up the phone, two random people meeting, a few executives not making a bad call or the market conditions not being right. 

I’m getting chills just thinking about it. 

The chart above shows total assets invested in ETFs as of October 10 2023 according to BlackRock. If you add up the green bars, you get ~$9.5 trillion dollars. That’s bigger than the annual GDP of Japan and Germany COMBINED. 

Act 1: Unlikely Inspiration

Truly groundbreaking products get their start as result of one or two things: 

  1. Unique observations about human behavior 

  2. Capitalizing on secular technology trends

Sometimes it’s both. 

In the case of the ETF, the SEC provided the initial inspiration for the creation of the product, although it was just capturing unique observations about human behavior and the unforeseen consequences of technological advancements (i.e Electronic Trading). 

After Black Monday, the SEC issued a report summarizing what contributed to the crash and steps to put in place to ensure it didn’t repeat. One of the report's identified culprits was the supply/ demand imbalances in equity markets that occurred as large institutions tried to execute massive trades of “portfolios of portfolios” or baskets of stocks. This supply / demand imbalance created information, capacity, and liquidity problems in markets that exasperated the fundamental factors which led to Black Monday.

If you want a cool read that summarizes the events, check this speech by former SEC commish Joseph A. Grundfest. 

Basically, the SEC called out that a new way for big investors to trade large baskets of stocks was needed so the market didn’t go nuts. The documentation of these findings were what initially kickstarted the ETF. 

Act 2: An Early Winner From an Unlikely Place

Despite Mr. Grundfest’s confidence that the New York Stock Exchange (NYSE) would figure out a solution to this trading problem, (mentioned in the speech I told you to read), it was the American Stock Exchange (AMEX) and the Toronto Stock Exchange (TSE) who would ultimately win. 

For context, the AMEX was getting its ass kicked by NYSE and NASDAQ, so it was desperate for something new and innovative that would make investors trade on the exchange. 

Thankfully in the late 1980s, AMEX rolled out something called Index Participation Shares (IPS) which was the first way investors could track and trade the S&P 500 without having to buy all stocks in it. Unfortunately, the CME (Chicago Mercantile Exchange) put an end to the product by filing a lawsuit which said IPS were too much like a futures contract. 

Inspired by the IPS and likely laughing at their litigious neighbors to the south, the TSE seized an opportunity to quickly follow up and listed its own index participation product called Toronto Index Participation Shares (TIPS) in 1990. Canada has at times, displayed a more progressive capital markets regulatory environment than the U.S and this led to the creation of the “first” ETF. 

The end right? 

If you're still following Act 2, you are probably wondering why some people say that the US created the first ETF. I’ll get to that but I wanted to make a point in Act 2 that the market you are in matters. The Canadians were able to birth the first “ETF” due to a more progressive regulatory environment but the US created the largest ETF and popularized it (in part) due to the size and scale of its capital markets. 

First mover advantage isn’t everything. 

Act 3: Disruptive Innovation with Your Grandpa

Imagine creating a groundbreaking new product only to have your buddy take it away because he complained to your Mom that you were too innovative. At the same time, that annoying neighbor up the block gets it going in his garage because his Mom is nicer than your Mom and his Mom doesn’t care about what your buddy’s Mom thinks.

That’s basically what happened.  

Seeing the success of the ETF north of the border (although it wasn’t called that yet), the unlikely dynamic duo of Nate Most and Steve Bloom were still hard at work at the AMEX trying to get an America approved version of the IPS listed in the US. 

They were an odd pair. Nate was in his 70s and Steve was in his mid 20s when the two met at the AMEX and started working together. Nate was said to be the “nice guy” while Bloom was “the executioner”. 

Legend has it that Nate was so nice, he explicitly told the Canadians about the IPS/ ETF concept before it was launched. This is apparently why they were able to launch it so fast. 

Nate’s genuine nice guy demeanor was also what helped him land a key meeting with Vanguard's Jack Bogle via cold call to advise on the mechanics of the soon to be ETF. 

Sometimes, it pays to be nice. 

Act 4: The ETF Is Eventually Born 

One of the biggest problems with getting the ETF off the ground was establishing its structure and mechanics. These structural and mechanical problems were the reason why the CME had their gripes with the IPS after all. 

Most people don’t realize how much technology and operational execution is involved in ETFs. They really are a financial innovation marvel. 

Eventually, Most and Bloom got the final inspiration for the ETFs modern structure from the concept of Soybean warehouse receipts trading. Without getting too technical, Soybean warehouse receipts trading is just a way to trade the ownership of Soybeans held in a warehouse without physically moving them. 

The team at AMEX applied the concept of Soybean warehouse receipt trading to the S&P 500 index and came up with the creation and redemption mechanism which underpins how ETFs are traded. This mechanism allows an investor to trade a single share of an ETF for a basket of stocks on an exchange.

Remember the Black Monday report? Seems like they solved the SEC’s problem. 

Just goes to show you that innovation is often a product of traversing disciplines.

Finally, after endless work and roadblocks, the first S&P 500 ETF was launched on the American Stock exchange in 1993 called SPDR or S&P Depository Receipts. It took almost four years for the SEC to approve it. 

I’ll let you guess what happened next… The product was an immediate hit and was beloved by investors everywhere right? 

Wrong!

Despite how important and successful ETFs are today, they almost didn’t make it after getting launched. 

Tune in to Part 2 for the rest of the story. 

Until next time, 

Ginger P.

The Ginger Professor explicitly represents the personal thoughts and views of the author only. It does not reflect the thoughts or views of any current or former employer or client of the author. All information referenced and contained in the article enclosed is for informational purposes only and does not represent advice of any kind.

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