The Birth of the ETF

“Bedlam on Wall St.,” screams the front page of the Los Angeles Times.1
“Stocks Plunge 508 Points … Worldwide Impact,” reports the New York Times.2
“Sell, sell, sell — the panic hits,” says the Sydney Morning Herald.3

The day was October 19, 1987, a day now known to investors across the world by the darker moniker “Black Monday.” Global markets plummeted so precipitously that the drop and the resulting damage to the stock market would ultimately prove more significant than the Great Depression.4 Almost immediately, regulators began asking, what had gone wrong?

The US Securities and Exchange Commission later said that automated orders for every stock in an index were at least part to blame for the crash, and concluded that the creation of a market maker to trade a basket of stocks "might alter the dynamics of program trading."5 It was an open invitation to the investment industry to create a new product.

Turning Crisis into Innovation

Fast forward to the winter of 1993, when a group of financial executives rang the opening bell of the American Stock Exchange to launch the first Exchange Traded Fund (ETF) in the US – the SPDR® S&P 500® ETF Trust6 – with the ticker symbol SPY. After more than three years of collaboration between State Street (then known as State Street Bank) and the American Stock Exchange, the basket of securities that tracks the performance of the S&P 500 index was finally making its debut.

The weeks leading up to the launch held many sleepless nights for the State Street team responsible for making sure all of the inner workings of the product were in good working order. There were many test runs that mimicked moving 500 securities from a broker-dealer to State Street while they were delivering back shares that can then be sold by the same broker-dealer on the stock exchange. It’s never been done before – no one is even 100% sure it can be done.

The American Stock Exchange (later acquired by the New York Stock Exchange in 2008) had initially approached the indexing pioneer and custody/clearing giant because of its proven expertise in managing to very specific criteria – in this case, State Street’s portfolio management skills and money movement capabilities. But the ETF presented some unique challenges.

With an ETF, while the product trades on the exchange like stocks and bonds, the underlying fund must have the actual holdings. For example, if it was a $100 million fund, it needed to have $100 million in assets comprised primarily of the index.

Complicating matters, since both the money and securities must move and be settled in real time, an audit has to be conducted in real time as well. Normally, this whole process takes 45 days. But for the ETF to work, it needed to be completed in about 16 hours – between the market closing at 4pm and the next morning before markets opened.

SPY ultimately proved successful with the institutional trading communities, large investors and even buy-and-hold investors.

Transcending Across the Waters

By 2001, ETFs had crossed the Pacific and were launched in Australia. On 27 August 2001, StreetTRACKS, now known as State Street Global Advisors’ SPDR, listed Australia’s first ETFs — the SPDR® S&P®/ASX 200 Fund (STW) and SPDR® S&P®/ASX 50 Fund (SFY) – two flagship equity funds used by retail and institutional investors alike in accessing the country’s large cap shares.

Listed on the stock exchange, investing in ETFs is as easy as owning a stock, and with a range of products to choose from, investors are able to target specific asset exposures and access an array of sectors, markets and countries. These features make ETFs attractive to self-directed investors and Self-Managed Superannuation Funds (SMSF), helping drive demand for ETFs in recent years.

Today, anyone with a broking account can build an ETF-focused portfolio covering a large range of asset classes. In Australia, there are over 259 ETFs managing $121.5 billion in assets.7

Source: ASX Investment Products Summary, as at 30 September 2022

Standing the Test of Time

One of the first tests of the ETF in choppy markets came in the wake of the September 11th, 2001 attacks when the US stock exchanges were closed for six days – which was the first exchange trading disruption of longer than four consecutive days in the previous 50 years.8 When markets reopened on September 17th, investors heavily sold off industries like the airlines that had been impacted. But then, a funny thing happened: market participants started using SPY’s price as an implied valuation for the constituents of the S&P 500, giving the market time to adjust and correct.

9/11 was the first but not the last time this happened. ETFs have shown that they add an incremental but essential source of liquidity to the market through a number of market closures, constituent trading suspensions, market dislocations, natural disasters and human errors, providing investors with a tool to dig out of problems in the market in real time.

Changing the Way We Invest

Almost 30 years on, ETFs have shifted the way investors think about how they invest. ETFs have become key building blocks to make asset allocation decisions. They have allowed investors to focus on outcomes with greater efficiency – through targeted exposure, matching portfolio goals with the transparency of the underlying holdings in a simple transaction.

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