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SPYing on ETFs: The History of an Investing Revolution

Jason D. Edinger, CFA

In today’s investment product-laden world, investors have an array of vehicles from which to choose and implement a variety of strategies. These vehicles are diverse in nature and differ greatly in size, liquidity, tradability, and fees. While the sheer number of different product offerings can feel overwhelming, it allows the investor to analyze, select, and combine different vehicles to maximize the statistical efficiency (Sharpe Ratio) and overall investment experience of a balanced, diversified portfolio. In a world where “less is more” is the right answer in nine out of ten instances, here more actually is more and it is helpful to take a Swiss Army knife approach to portfolio construction.

At RINET, we are vehicle agnostic. This means that, all else equal, we do not maintain an overarching bias toward any vehicle, but rather we select the appropriate vehicle for each investment. For instance, in the municipal bond space, we might prefer the managed account structure. For emerging markets exposure, we may elect to invest in a 1940-Act open-ended mutual fund. The choice of structure in all cases is arrived at from a bottom-up analysis of the investment strategy, which is only implemented upon completion of the necessary due diligence and approval of the strategy.

Historically, mutual funds have been the prevalent vehicles used on our investment platform. There is a lot to like about the mutual fund construct including: daily liquidity, transparency, and familiarity. However, recently we have begun to introduce a greater number of exchange traded fund (ETF) options into our guideline portfolios, notably in areas where passive exposure is preferred and/or the returns from active management fail to justify the risks assumed or expenses incurred. In such instances, ETFs can play an integral role in balancing overall portfolio exposure to asset classes, benchmarks, and styles.

Quite simply, an ETF is a marketable security that tracks an index or basket of securities and trades like a stock on an exchange. I should note that, for the purposes of this article, when I refer to ETFs generally I mean passive, low-cost exposures to market value-weighted indices, as opposed to actively managed ETFs, which are known by many monikers to include “smart beta,” “factor-based,” and the like. ETFs of this nature are relatively new products, the specifics of which lay outside the focus of this article. Meanwhile, the benefits of ETFs as I define them are numerous, including liquidity, transparency, and favorable pricing relative to an actively managed strategy (all else equal).

To truly understand how ETFs work and what makes them so appealing, we must look to history as a guide. After all, ETFs are the relative new kids on the block, having only been introduced officially to the mainstream in 1993. Compare that with the first mutual fund of the modern era, which was created in 1924 as the Massachusetts Investors Trust. Mutual funds have had nearly a seven-decade head start on their younger, exchange-traded brethren. To understand the important role that ETFs play in the investment landscape today, we must first understand where they came from and how they have risen so meteorically in less than 30 years.

The story of the ETF is fascinating. Following the October 19,1988 Black Monday crash in the Dow Jones Industrial Average (DJIA), which remains the biggest single-day crash in stock market history (down 22%), the Securities Exchange Commission (SEC) conducted a rigorous investigation and produced a conclusive report containing a mind-numbing 840 pages. Without going into details surrounding their findings, the SEC questioned if market makers could have grouped individual securities into large, diverse baskets, might most the carnage been avoided?1

This question piqued the interest of high-ranking American Stock Exchange (AMEX) product developers (principally Nathan Most and Steven Bloom), who were keen on the idea of including key stocks in a single basket that could be traded individually, without unduly influencing price action of the larger market. This novel idea formed the basis for their research and the duo began work on the project immediately. Taking inspiration from commodities futures trading, whereby the physical commodity is stored in a warehouse and a contract for future delivery is bought and sold by hedgers and speculators, Most proffered that a virtual warehouse could similarly exist for a basket of stocks. Investors could trade this instrument throughout the day with no money changing hands at the basket level. The all-important concept of in-kind creation and redemption was born.

The key to understanding how ETFs work mechanically is the creation/redemption process. This idea, conceptualized by Most, allows ETFs to obtain exposure to any desired index and facilitate daily trading without incurring massively prohibitive costs. Here is how it works: Authorized Participants (APs) oversee market activity and monitor the supply of all ETFs on an ongoing basis. They are usually large institutions responsible for collecting shares of individual stocks and bonds which comprise a given index (the S&P 500, for example). When a sufficiently large buy order is placed for an ETF, such that market makers cannot fill the order with their own inventory, the AP will collect and deliver all shares in that index to an ETF sponsor (State Street or iShares, for instance).

The sponsor bundles all the shares into a basket and delivers them back to the AP, who in turn delivers it to the market maker and the trade is facilitated. The redemption process is similar, and is essentially the opposite of the creation process. It is important to note here that this concept of in-kind creation and redemption represents trading in the primary market, whereas buyers and sellers trade ETFs in the secondary market throughout the day on stock exchanges, just as they would individual shares of Apple or Google. The overwhelming majority of ETF trade volume occurs on the secondary market and only a small portion actually constitute trades in the underlying stocks.

Armed with this creative idea and a working mechanism for its implementation, Most and Bloom teamed with State Street Global Advisors for custodial and trustee services. They decided that the appropriate index for the ETF to track was the S&P 500, and promptly filed an application with the SEC. After a long, arduous process, the SEC finally approved the ETF basket product in 1993. Again drawing on the notion of commodities warehouses, they named the new product SPDRs (Standard & Poor’s Depositary Receipts) and crowned it with the fitting ticker of SPY. The first ETF was born.

The early days of SPY’s life were anything but certain. Although it traded a million shares on its first day, activity began to tail off with daily volume falling to just 18,000 shares in a few short months. Given that there was no official sales force charged with promoting SPY trading (indeed, no one was compensated in any way to sell the fund), it had to rely on word of mouth and mental adoption on the part of the mass market to grow.

Eventually, the ETF began to cultivate a legion of true believers, who helped spread the word and raise the fund’s profile. Throughout the years, it has undergone astonishing growth, and today it is the world’s most traded security. See the following short review of some of SPY’s statistics:2

  • Volume: SPY trades almost 6.75 times more than Apple, which is the largest security (by market capitalization) in the world;
  • Liquidity: SPY offers some of the narrowest spreads among all S&P 500 ETFs, consistently hovering between 0.005% - 0.006%; and
  • Size: SPY is the largest ETF by assets ($197B by 09/30/16 and closer to $220B by 01/01/17) in the industry. The second largest (IVV – the iShares Core S&P 500 ETF) has $80B of assets.

SPY also accounts for nearly 50% of the overall equity options traded in the U.S., a truly amazing amount of volume.

While SPY is undoubtedly the most famous, high-profile fund in existence, ETFs in general have revolutionized the investment industry. There are now over 6,000 tradeable ETFs, and the industry collectively took in $284B of assets in 2016. That is nearly $1,000 for each U.S. citizen. ETFs currently account for nearly 30% of the dollar value traded on all equity exchanges. The website predicts that the industry will surpass mutual funds by 2025 (in terms of assets managed), if not sooner.

Another interesting facet of the ETF story is that they have come to be used by the same structures that they are vying to supplant. Hedge funds, mutual funds, and separate account managers often use ETFs within their portfolios for a variety of reasons, including hedging or augmenting other portfolio exposures. They are also used at times as a tool to enhance liquidity. While their use among institutions has always been strong, ETFs have also seen a surge in retail use – the so-called little guy – to access certain markets once only open to the privileged few.

This is not to say that the mutual fund, separate account, or limited partnership structure is withering on the vine. Indeed, one of the more appealing aspects of ETFs is that they are used as a tool alongside other vehicles. Combined, this mixture of investment structure provides for diversification and more targeted exposure that is most appropriate for the underlying investment, whether it be equities, fixed income, hedged mandates, or commodities. We are devout believers that the combination of overall portfolio exposures and instruments, properly balanced in accordance with the appropriate risk-return framework, is the best way to implement our guideline portfolios.

The story of SPY and the ETF industry is undoubtedly one of success. ETFs clearly have gained traction within the larger investment management industry, and their increased use within portfolios cannot be disputed. At RINET, we acknowledge both the many benefits and drawbacks of such a structure, and choose our spots carefully in terms of which vehicle to select to implement each investment. We do not believe that the best solution is achieved using a blanket, one-size-fits-all approach. Rather, we feel that ETFs are a great supplement to portfolios that are already skewed towards active management. By combining low cost, passive ETF exposure where it makes sense with best-in-breed active management, we think we can leverage the benefits of both constructs while simultaneously minimizing their disadvantages. Think of it as an increase in the portfolio’s Sharpe Ratio. Or, in layman’s terms – the best of both worlds.



1 Bloomberg

2 State Street Global Advisors