Richard Morin
Update :
21
June
2023
Update :
June 21, 2023
Earlier this year, our American friends celebrated the 30th anniversary of the exchange-traded fund (ETF). This is curious, because many Canadians (including the author of these lines) have held ETFs for 33 years now. Indeed, it was in 1990 that the Toronto Stock Exchange launched TIPS - Toronto Index Participation Securities - the forerunner of the iShares S&P/TSX 60 Index ETF (XIU). So, what's going on? Are the Americans claiming authorship of a Canadian invention?
No way!
In fact, if someone "stole" someone else's idea, it's the Canadians who are guilty.
ETF design
To understand how and why the first ETF was created, we must go back to the 80s and what was called portfolio insurance and program trading. It was the beginning of the modern era of financial markets. Portfolio insurance consisted - in the event of a sharp decline during a trading session - in selling futures contracts and options on stock market indices. Typically, these derivative sales were triggered when the index fell by 5% or more during a trading session, and were intented to protect the portfolio against the worst of the declines.
By the mid-1980s, many institutions - pension funds, insurance companies and others - had set up such programs, on the advice of major brokerage firms. The market makers - whose job it was to buy these derivatives - in turn had to hedge their risk by automatically selling all the securities making up the stock market index simultaneously on the stock exchange: this is called program trading.
The ultimate test of portfolio insurance and program trading came in October 1987. The market had been volatile the previous days and when the New York Stock Exchange opened on Monday October 19, a drop of more than 5% was reached. The markets were then literally flooded with sell orders for derivatives and stocks, and within minutes the stock indices had suffered a drop of 22%!
As usual, the market recovered fairly quickly from this downturn, but the regulator, the Securities and Exchange Commission, launched an investigation to fully understand this stock market crash and prevent similar events in the future. Program trading was quickly identified as the culprit. For the SEC's principal analyst working on the case, the solution was simple: that these orders to sell "baskets of securities" should not be sent haphazardly to the trading floors, but rather routed to a "parallel" market (a sidecar in SEC jargon) where a buyer could acquire all the securities in the basket that the seller wanted to dispose of.
Without realizing it, the SEC had just designed the ETF.
A long gestation
In order to move from the initial concept to the ETF we know today, a financial institution had to take an interest in the project and invest in the launch of a new product. It is therefore very natural that Vanguard and its founder John Bogle - a pioneer who invented the index mutual fund in 1976 - were approached. Their answer? It's a bad idea and this product won't work [1]!
Rather, it was a team from the American Stock Exchange [2] and State Street Global Advisors that worked for 3 years to launch, in 1993, what is still the world's largest ETF: the SPDR S&P 500 ETF.
And the Toronto Stock Exchange in all this?
The world's first true ETF
If the launch of the SPDR by the American Stock Exchange took 3 years, it is largely due to a battle between regulators [3] which delayed the project for many months.
In the meantime, the Toronto Stock Exchange - which always followed developments south of the border with great interest - had launched its own ETF project, culminating in the 1990 launch of Toronto Index Participation Securities, forerunner of the iShares S&P/TSX60 Index ETF, Canada's largest ETF with some 11 billion in assets.
The ETF is therefore indeed an American invention, but the Canadians beat them at the finish line!
The family has grown
33 years later, there are more than 1,300 ETFs listed on the Toronto Stock Exchange, over 3,000 in the U.S. and 9,000 worldwide, with total assets of almost 9 trillion USD. ETFs now allow you to invest in both bonds and stocks, in Canada and in all foreign markets.
The exchange-traded fund is the biggest investment innovation in over 50 years. It allow all investors - regardless of portfolio size or level of financial knowledge - to invest in a diversified, balanced portfolio at low cost. ETFs made it possible to restore the balance of power between investors on the one hand and financial institutions on the other.
Happy ETF Day!
Notes
[1 ] It wasn't until 2001 that Vanguard launched its first ETF. Today, the firm is one of the world's largest ETF issuers, with assets of USD 2 trillion.
[2 ] The American Stock Exchange has since been absorbed by the New York Stock Exchange.
[3 ] The Securities and Exchange Commission and the Commodity Futures Trading Commission both claimed to be the regulator of this new product. In the end, the SEC was chosen.