Reinventing Investing: Building the First US ETF
How SPY Revolutionized the World of Investing
“Bedlam on Wall Street,” screams the front page of the Los Angeles Times.
“Stocks Plunge 508 Points … Worldwide Impact,” reports The New York Times.
“The stock market crashed yesterday,” The Wall Street Journal’s front page plainly states.
The day is October 19, 1987, a day that would soon be known to investors across the world by the darker moniker “Black Monday.” Global markets plummeted so precipitously that the drop and resulting damage to the stock market is believed to have been more significant than the Great Depression. Almost immediately, regulators began trying to figure out what had gone wrong.
In the process, investigators at the Securities and Exchange Commission noticed something: The stock market did not have a single security representing the broad market in the way that the futures market did with futures contracts on the S&P 500® index. Thinking that such a vehicle could potentially have minimized damage — and perhaps helped avoid the crisis entirely — the SEC expressed interest in developing an entirely new kind of security.1
Out of Crisis Comes Innovation
Fast-forward to the winter of 1993. A group of financial executives ring the opening bell at the American Stock Exchange, launching the first exchange-traded fund (ETF) in the United States, with the ticker symbol SPY. This moment is the result of a three-plus-year collaboration between State Street and the American Stock Exchange, which in 2008 was acquired by the New York Stock Exchange. A basket of securities that tracks the performance of the S&P 500 index has finally made its debut.
One face, however, was missing from the bell-ringing celebration. Jokingly referred to as “the Plumber” by his colleagues, Jim Ross was back in his Boston office, where he’d been tasked with making sure the launch went smoothly. The weeks leading up to the launch held many sleepless nights for Jim and the State Street team responsible for making sure all of the inner workings of the product were in good 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 could then be sold by the same broker-dealer on the stock exchange. It had never been done before — no one was even 100 percent sure it could be done.
The American Stock Exchange had initially approached the indexing pioneer and custody/clearing giant because of its proven expertise in managing based on 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. “If it was a US$100 million fund,” Jim says, “it needed to have US$100 million in assets comprised primarily of the index.”
Complicating matters, because both the money and securities must move and be settled in real time, an audit had to be conducted in real time as well. “Given that we were seeded not just with cash but also with the 500 securities of the S&P 500, we had to have an audit of 500 individual securities,” Jim explains. “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 4 p.m. and the next morning before markets opened. Significant planning was required to ensure that the financials could be prepared and the audit could be completed. That made for some late nights.”
SPY ultimately proved successful. “It caught on with institutional trading communities, large investors and even buy-and-hold investors,” Jim says. “They saw the ETF as a way to buy into the S&P 500 in a securitized, cost-effective way.” One significant early investor in SPY was a pension fund not from the United States but from Australia. “Back then,” Jim says, “buying a mutual fund required you to fill out an application. It was a very different process. This was something you could buy on the exchange. So, suddenly, you had foreign pension funds buying and holding it to get pensioners halfway around the world exposure to US equity markets.”
Real-Time Problem Solving
A quarter-century later, while there are now 5,000 ETFs that track specific industries, sectors, commodities and geographies, SPY remains the largest2 and most traded ETF.3 In fact, SPY trades 4.2 times more than Apple (AAPL), which is the largest security in the world by market cap.4 That volume, combined with the size of SPY’s assets, its liquidity and its resilience in varying marketing conditions, has been important in building portfolios for some of the world’s most sophisticated investors. Today, Jim is the chairman of State Street Global Advisors’ family of ETFs. He’s most proud of how ETFs continue to help investors in times of market turmoil.
One of the first tests of the ETF in choppy markets came in the wake of the 9/11 attacks, when the US stock exchanges were closed for six days — the first trading disruption of longer than four consecutive days in the last 50 years.5 When markets reopened on September 17, investors heavily sold off industries like the airlines that had been impacted. “That was an extremely uncertain time for the global markets and a scary time for investors,” says Dave LaValle, head of ETF Capital Markets in the US. 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.
September 11, 2001, was the first but not the last time this happened. ETFs have added an incremental but essential source of liquidity to the market during 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.
A Platform for Innovation
Jim compares ETFs to the iPhone. “The iPhone platform was a significant invention, no doubt, but the real revolution has been all of the innovative ways people have found to harness the smartphone’s power in daily life. Similarly, not all innovation in the ETF space comes from providers. A lot of it is user driven — in this case, by investors.” He points to insurance companies using ETFs rather than bonds as investment vehicles for their general accounts, and financial advisors using ETFs for asset allocation and diversification planning, as well as a number of wealth management firms using ETFs to package their investment beliefs into outcome-oriented products for their clients.
Rather than being a threat to the traditional advisor, ETFs create a new model that gives advisors the ability to outsource the investment component, so that they can focus on client outcomes. ETFs even help mutual funds innovate. Kat Sweeney, head of ETF institutional sales in the US, notes: “Before ETFs, a $100 million inflow into a mutual fund would mean the portfolio manager had no choice but to either leave it in cash or sweep it into a money market fund. Now, that money can be put to work in an ETF that achieves similar exposure and is aligned with the fund’s objective.”
Despite all this, ETFs still represent less than 5 percent of the entire investable market.6 But with the ETF’s inherent liquidity advantages over individual bonds, because of intraday trading and transparency on pricing, many believe that up to 30 percent of insurance companies could be moving assets into ETFs.7 Millennials in the United States are using ETFs more than any other demographic group, and their usage has increased 60 percent in three years’ time.8 Jim is particularly bullish about the global potential of ETFs. “Right now, there are more middle-class Chinese citizens than there are American citizens total. ETFs are just scratching the surface in these markets.”
Changing the Way We Invest
Twenty-five years into their existence, ETFs have shifted the way investors think about how they invest. ETFs have become key building blocks when making asset allocation decisions, and they’ve allowed advisors to focus on investor outcomes with greater efficiency — through targeted exposure to match portfolio goals and improved transparency of underlying holdings, enabling a more streamlined due-diligence process. “It’s not that long ago that we were trading in fractions and using hand signals to communicate on the trading floor,” says Dave. “Over the past 25 years, since the launch of SPY, the markets have become increasingly automated and complex. However, this complexity has resulted in tighter spreads and greater transparency. Any way you look at it, this has been a win for investors.”
Still, Jim refuses to take credit for any of it. “When this all started, we thought that the ETF would be used mostly by trading institutions or maybe some hedge funds. Boy, were we wrong.”