The Birth of an ETF

The ETF industry is humongous. Like, worth nearly $3 billion dollars kind of humongous. But did you ever even stop to wonder how it all begun?

You’d have to go all the way back to 1988 when a single, 840-page report landed on the desk of the Vice President of new product development at AMEX. No – not the credit card company. This AMEX stands for The American Stock Exchange, currently the third-largest stock exchange by trading volume in the country – just behind the New York Stock Exchange (NYSE) and NASDAQ.

It may seem a bit weird when you think about it…but stock exchanges are companies. Just like any other company – with employees like Nate who have titles like vice president of new product development or Martha in accounting.

And the vice-president in question, Nathan Most, was looking through this massive report. Weighing in at a meaty 5lbs, it came directly from the offices of the Securities and Exchange Commission (SEC). He then attempted to dissect the root cause of the market crash that occurred on October 19, 1988.

If that date seems at all familiar, it’s because it’s also known as Black Monday in the ‘biz’. That was the day the Dow Jones industrial average crashed 22% in a single day – the biggest one-day crash. Ever.

At the time Most was thumbing through this monstrosity of a report, AMEX was looking for ways to grow…to compete with the big boys. What they found in the report inspired them.

Longing vs. Shorting

In conducting the post-mortem of Black Monday, the SEC nerds found out that a big reason for the crash was the existence of program traders (bots) and portfolio insurance. Portfolio insurance is a strategy used by many investors back then. It’s a way of hedging your investments. One way it’s used, for example, is if you own shares of Apple (long Apple) you would also short shares of Apple (short Apple). At the same time.

Simply put, when you are long a stock, you gain when the stock price increases. When you short a stock, you gain when the stock price decreases. So…if you were to long 10 shares of Apple, and then short 5 shares of it, that’d be a simple way to apply the strategy of portfolio insurance. When the price of a share of Apple goes up, your gains from your longs are offset by the decreases in your shorts. On the other hand, though, when the price of Apple goes down, the gain from your shorts will offset the decreases in your longs. It’s not a great way to make a lot of money but it manages risk pretty well.

ETF

So on Black Monday when the prices of stocks started to decline, the portfolio insurers started to sell their hedges. The madness then triggered the bots to sell as well…and everything went down the toilet from there. The selling and crazy volatility was basically the main problem and in their 840 page report, the SEC called for something that could avert that. They asked for a single product that investors could have used that might provide a “liquidity buffer”. By trading this product and not the shares themselves, the market could have avoided massive volatility.

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And when AMEX read that, they said “sure, we’ll create that product.” And that was the first ETF.

An ETF, or exchange-traded fund, is a type of security that tracks an index. So it might track something like the S&P500 and can be traded on an exchange (as its name implies), just like a regular stock. And in 1988 the SEC envisioned ETFs as being the solution to market volatility on the order of what happened on Black Monday.

Wait, so does that mean if you own an ETF that you don’t own any shares? Well, yeah…kinda.

To understand why that is, we have to look at how an ETF is created in the first place.

How ETFs are Created

ETFs are created through a process which involves just a few large investors. These investors can be big banks or investment companies who have the ability to create or redeem parts of an ETF. Creation occurs when one of these investors buy up the underlying assets of the ETF. These underlying assets are then traded to the company managing the ETF in exchange for a whole mess of ETF shares.  The amount of ETF shares given are known as a creation unit and can range from 10,000 to 600,000 for a single unit. The investor can keep these shares or sell some (or all of them) on the stock exchange.

So you’ve got your hands on some ETF shares, but do you actually own the underlying asset? If the underlying asset that resulted in a creation unit was a ton of shares of Apple – do you own them? If you go and buy a share of Apple, you own that share. You could frame that share (essentially a paper certificate) on your wall. But with an ETF?

The answer: yeah, kinda…if you had enough shares to come up with a single creation unit. So if you’ve got 50,000 shares of that ETF, then you could conceivably exchange the creation unit for the underlying security.  Otherwise your only real option is to sell your three shares of your ETF on the open market.

Coming back to AMEX, it just so happens that they went on to create SPY, the world’s most traded security. On average, it trades $25 billion worth of shares in a day. That’s four times more than Apple in second place. With $166 billion in assets, it’s also one of the largest ETFs out there.

In creating SPY, these guys succeeded in launching what would become a $3 trillion dollar industry and changed the ways individual investors invested in the market. Crazy…

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