Episode 18: The Obscure Report That Spawned the ETF Industry

trillion dollar industry? Is that right? And that industry is the e T F And I think almost everybody at this point who is aware of markets knows what e t s are. Their exchange treated funds. You can use them to make a bet on the STP as a whole. You can use them to make a bet on gold, and you can use them to do crazy stuff like make a three x levered bet on junior gold. Miners do that all the time. But it's like a basket of things, right, and it trades like a single stock

on an exchange exactly right. And these e t f s have been hoovering up assets, as you said, trillions of dollars away from traditional funds, from traditional money managers, and it doesn't look like they're slowing down anytime soon. And not only that, they continue to innovate. So there are more and more new kinds of e t F s all the time. From what humble beginnings did the e t F market come to us? This is the fascinating thing. We're going to discuss with our colleague Eric Balcunas.

He has a new article out in Bloomberg Markets magazine called the e t F Files, and that's based on a new book that he's publishing. And so it turns out, Eric, thanks for joining us, thank you for having me. So the e t F, this monster innovation that's changing how people invest, came out in a weird way. It came out thanks to basically a memo, right yeah, memo, will be putting it mildly at eight hundred and forty page governed report is really where the seed for the e

t F was found. So what happened was in the seven crash called Black Monday, right the worst, the worst stock market crash in history. There was SEC spent four months writing a report about what happened. They were trying to figure out what really not the macro events that caused selling, but what exacerbated the sell off that it was so brutal, and Key tell us what did happen? Because we can't pass up an opportunity to talk portfolio insurance.

I'm sorry. Sure. So what they found was, when the dark clouds were going over the market, institutions had all started using something called portfolio insurance, which essentially was a strategy that involved shorting futures right based on indices as soon as the stocks they held started hitting a certain level. So essentially what happened was on that day there were just weren't that many buyers for the people trying to

sell insurance. Then on top of that, you had program traders who were arbitrage in the futures to the individual stocks, which involved buying the futures and then selling all five hundred or how many of our hundred stocks at the same time, right, So what happened was those program traders stepped in and they were putting all the cell orders

on the individual stocks. That caused more panic and all all of a sudden, Really what you had was all these forces looking to sell individual stocks all at the same time and that's when you had the crash. And how much was the crash that day the crash it was a five D eight point drop in one day. I mean, we've had like some flash crashes in recent years, but that really puts it into perspective. It also reminds it.

You know, we've blamed high frequency trading and all kinds of stuff on modern flash crashes, but you can get some extraordinary moves. It seems about just about any area, that's right. Yeah, Okay, So the SEC put out after several months of studying that crash in they wrote an

eight hundred and forty page memo. And what was in that memo that led to the e t F Sure on chapter three, right deep into the into the actual white paper memo, there was something where they talked about if an alternative approach were to be examined, so they used that language, and what they're basically saying was the SEC was thinking that the futures market volatility and sell

off had transmitted to individual stocks. So they thought, you know, if there was only a way to do basket trading, so you didn't hit sell on five stocks at once, but you hit sell on a basket and you had market makers and specialists who were able to trade those baskets. It might have provided a buffer in between the futures market in Chicago, which the SEC doesn't have any regulation over, and the individual stocks in New York, which they do. So they just put it in there is maybe a

possible alternative approach. However, they did use the word product. And then the two guys at the m X, who were hungry for some more volume because that exchange was really in third place at the time, read this and really looked at it as a product propos Well from the SEC. I mean, it's kind of a creative approach, right to read an CEC paper on this huge negative event in markets and think I have a product idea out of that. Yeah, I mean the SEC does use

the word product and they say alternative approach. Remember they worked at am X, right, So exchanges were really into this report. Because I asked Stephen Bloom, who was one of the two guys who read it, they said they were riveted by every page. I thought, who would read an eight d forty page government report, But they did, and they you know, they got rewarded for reading every

word like that, So they were really excited. One of the quotes that we found from him was that he said he walked into his boss's office and said, here's an opening. We can drive a truck through this exchange. In particular, MX was hurting, so they were really looking for something. So they had their eyes wide open when

the report hit. I just want to pause and say, I love that point that he who hears you, who reads an eight hundred and forty page government white paper and really notices all the details, there's a reward to that they deserve to make money. Yeah, exactly, I think. So Eric tell us about the product that they eventually came up with. What were the actual beginnings, right, So they thought, okay, well let's get a basket trading product. Right.

Their first idea was to go to Jack Bogel at Vanguard and see if they could trade an SMP index fund for from Vanguard. Jack Bogel met with Nate Most, who Nate Most and Steve Bloom with the two guys and basically said thank you, but no thank you. And when I interviewed Jack Bogel, he said, Nate Most walked into my office. I looked at his proposal. I said, I'm not interested anyway, but I will give you three criticisms flaws that I think your product has that if

you fix them, might be better. So that's what Bogel claims. So basically he said no, thank you, because Jack Bogel wants nothing to do with trading anywhere near his funds. You know, he's anti trading, and this would be a product that would trade. So that was really where the difference lies. So Nate Most said that that meeting got him thinking about a way where you could trade a fund but not drive up cast us and the fund from people coming in and out of it. That was

the big problem. And this is where the I think the value from Nate Most than the AMEX came in to make the e t F more than what the SEC called for. And that is that Nate Most was seventy four years old and he used to be a commodities trader, and he used to be president of the Pacific Commodities Exchange, and he basically looked at the paradigm of the commodities warehouse receipt, which is where you know, palm oil or coco. You don't want to move the

merchandise back and forth. So what you do is you store it in a warehouse, you get a receipt, then you trade the receipt. That way you don't have to move anything, and then he saves costs, and that saves costs. Then you could gather up the receipts at any time, go to the warehouse and get your commodities back. So that that paradigm was then applied to the sort of the SEC's general idea, and that really was the sort

of foundation of the et start. So let's just break down what we've learned, because I think this is really fascinating. And for those who don't know, Jack Vogel famous for his belief in indexing not trading, the key to winning and investments is low costs, and so theoretic at least something like an SMP index fund could have appealed to him. When he saw this product, he said, hey, this is

a trading vehicle. He's not into vehicles that make it easy to get in and out of the market and be there's too much costs involved in the internal running of the fund. But when they solved that problem, it still didn't really solve the fact that it's a trading vehicle. But it did become a low cost product that people can use to make a directional bet on the market

in a way that we didn't have before. Yeah. And I think what it did was the meeting with Bogel, even though it was never going to happen with him because he was anti trading, the meeting pushed them to think of something different. And that's where bringing this commodities paradigm is why et f s can trade upwards of eighteen trillion dollars a year. They trade all day long, right uh. And if you look at like sp Y for example, trades about billion dollars a day. That's the

big sp five, that's the big SMP. That's the one that they first designed, these two guys. But yet someone like my aunt Joyce could go into the SMP Spy for ten years and that trading every day does not bother or drive up costs for her long term investment. And that is where the model really was something special.

And when you talk to the guy who was one of the lawyers who wrote the market break report, the SEC document, he said when he saw the proposal come in from am X with this design, he was blown away. It was way more than he thought when they were writing it. So he thought this product would had much more utility than even they thought when they said we need something for a basket trading product. So hold on

one second. They borrowed the commodities warehouse idea with the sort of trading receipts, but you still need a virtual warehouse for the shares, right, how did that come about? Right? So there, right, there's no warehouse, right, So instead of a warehouse is called a custodian. So State Street was one of the first obvious places they went, and so

that's became the custodian for the stock. So the custodian is the virtual warehouse that and today every et F needs a custodian to store those stocks or bonds or whatever holding. And that is what makes the e t F slightly different than a derivative. Some people say E

t s are a type of derivative. The fact is that these stocks that are in the spy or any E t F our literal picture, and they're literally stored in a warehouse just happens to be a custodian's electronic But the fact is those are receipts for those physical they're physically backed and that that's what makes some difference in like a futures contract and tell us how those stocks actually get in the virtual warehouse, if you will, because that's a process that's really important for e t S,

right sure, It's called the creation redemption process. And this is where I sometimes teach courses on e t S where the students get really like confused and bored. I'll be honest. That's why are our listeners are not going to give our Our listeners are very sophisticated, wonky people, and this is the part they're going to be most excited about. So well, and that's why I went into the story of how the first t t F came about, because when I tell the story, people get it more. Right,

when I explain the commodities visual, they understand it. So the way creation redemption works is an authorized participant, which is a gigantic bank connected to the system with you know, a lot of money. Basically they are Every et F has several aps that are assigned to it. When a new creation is done, the AP will hand in the basket, which is say five s in the SMP into the state into the issure state Street and in return they get fifty shares of spy and that would be like

the receipts. Then they sell those on the exchange, and that's where those receipts will trade. And then if there's a redemption, the same thing will happen. They'll take spy shares, hand them into State Street and get their five stocks back. And then that is sort of the creation redempture process, which I sort of equate to the flux capacitor from Back to the Future. You know it's in that movie. It's how time travel works. What I just described is how the e t F has been so resilient in

several market stress events. And I think, you know, people are waiting for them to blow up, but that what I just described does make them, I think a little more resilient than people think who are sort of just learning about them. So what actually motivates the a p s to bring their shares and things to this warehouse and get the sort of the E t F share

in return? Right, the AP gets a small cut from a spread when they deal with the market makers, and they also are able to do arbitrage, and arbitrage sounds like a bad dirty word, but it's actually really effective for e t s because if the basket, if the stocks, if the e t F price starts to go a little higher than the value of the stocks, the AP can arbitrage by handing in the e t F shares and buying the underlyings or vice versa. So they can always arbitrage the e t F versus the basket by

using the creative redemption process. That in effect is a natural economic motive for them to keep the price close to the n A V. And that's a huge difference on e t F compared to close end funds, which don't have that ability to create and redeem new shares any time, because clothes and funds are limited shares outstanding, so that there's always massive premiums or discounts. That is

one sort of way the E t F evolved. These then fun to you know, improve that model, because if I'm an authorized participant and I see a huge difference between the underlying shares and the share of the E t F, I'm gonna want to come in and take advantage of that and try to arbitrage it. Out right, it's free money, it's a risk free profit for that

APay right, and that you know, again everybody wins. Again, that economic incentive is crucial, and that is the secret sauce that keeps everything going and makes the regular retail investors get a price that's really close to the fair value of those of the basket of stocks. All right, let's go back to the stories. So now we understand we have this the SPY which still trading, the gigantic SPI index fund. They launch it, how does how did it go? How did they do it attracting people do

trade it? And how did that work out? Right? So well, first I had to wait four years to get SEC approval. SEC did not know what to do with this. They were even though they suggested the reason it took four years. It had to go through which is the strictest of regulations. So finally got approval under the that's what regulates mutual funds. So when it came out in ninety three, it had a good first day. They had a lot of hype.

They had a large spider hanging from the ceiling and the trade a million shares, but a spider because because they're called the Standard and Poors Depository receipts with acronym spider. And back to the commodity warehouse receipts. Depository receipts is even in the name of Spider, which kind of connects to the commodities warehouse receipts. But they traded a million shares, but then it dwindled down. But even more, ETFs don't offer brokers any commission to sell them. It's why people

like them, it's why they're so low cost. But it also inhibited some of the early sales growth. So what happened it was some true believers who really thought, wow, this is a great product. They were doing guerilla marketing. When it really came back after like two years, they

were almost thinking of closing it. It It traded eighteen thousand shares one day about five months after launching, which is that's that's like less than the Global X Solar Energy e t F trades today, So it was not trading all. So you had people who were just out there figuring out ways to sell it, and some institutions caught on.

But really what happened was the nineties kicked in was like an epic year for the market, so just buying the SMP became a big deal, and then that really was the supreme catalyst and it never looked back at doubled assets every year after. How important was the rise of sort of discount retail brokerages online brokerages in the mid nineties, you know, in terms of you mentioned that

there was no brokerage commission on these things. But once people got into this idea during the nineties market boom of investing for themselves and trading, did that help their rise? Yeah? It did, believe it or not. Though institutions were some of the first early buyers, like pensions, And there's even a story about a rich Seattle investors in the mid nineties and the guy was like, he's very, very wealthy

from Seattle. You guys could probably guess who it is like to use spy because they could buy options on it to protect their position. So the first adopted as were big institutions. Because some of the institutions like using in play who is the investor? I think it's Bill Gates, but he wouldn't tell me. I'm just thinking what they think that he got he was into them for his personal investments. Yes, interesting, yeah, but we don't know that. We don't know. That's the second. Very wealthy is why

I thought and from Seattle. Maybe Paul Allen, I don't know one of those guys, probably Steve Jobs isn't that rich yet, but I don't think that's right. He was from California. Well, okay, wait, so we've told the story. We're now at this point where you know, the s p Y e t F is trading like twenty five billion worth of shares a day. But beyond just the story of that particular e t F, we've also had

the entire industry kind of grow around it. We have all these new kinds of e t F. Tell us about what's changed since the early days when you look at it. You know, in the SEC commissioner who was around in the late eighties who I interviewed, he said, well, we didn't envision anything non stock baskets. We thought just some stock baskets would really help with the stock market volatility. But now you've got fixed income ETFs. You've got gold

g l D was a game changer. That was the first commodities et F. Now you've got a hundred and fifty commodities ETFs. Fixed income. As you know, we've discussed this several times. It's a hot topic because bonds don't trade like stocks. So now you're taking something antiquated and over the counter and putting it in a stock like vehicle,

and that's created some concerns. And then you've gotten things like leverage ets which whold total return swaps, or oil futures that hold you know, literally hold futures contracts, and now you're basically buying an et F that is like your personal oil futures trader. So they've expanded into every asset class and what I call standardization, just like a ubs port or a gas bump is standardized, you know

that need for consumers. The e t F has basically made everything trade like a stock, which means you can see the pricing, you can buy it easily, and it's taxed like everything else. So that kind of standardization, I think is one of the big reasons people like using them and for a long time, or you know, when I think of e t F, so I think of something really simple like SMP gold, but something sort of

underlying is passive. But increasingly the composition changes and they're active e t f s and their e t F based on formulas where the where the stocks are changing. Right, Yeah, that's a whole thing called smart beta also slightly controversial, but basically the early products were just you know, their market cap weighted beta one they call you know whatever.

That very simple understand So some people came along and said, hey, look, academics have studied what factors active managers rely on to get alpha, such as tilting to small caps, tilting to value, tilting to volatility momentum, and they've taken these tilts and

they've put them into rule based passive products. And so smart beta is sort of fills the void that existed between pure active and pure passive, and that's a four hundred billion dollars section of the e t F world, and that is where you're getting a lot of the new players like Goldman, Sachs and JP Morgan. They think smart BATA is the future because there's ten trillion dollars in active mutual funds right now and a lot of that money is going to go away because the mutual

fund structure. So they think that a smart beta will be a place where a lot of the new assets will go from the money that's coming over from pure active because they want to try to beat the market, but they don't want to pay the fees and they want something that's easy to trade, and they don't want to capital gains taxes either. So smart beta e t f s are in some people's eyes, a real interesting

arm of the e t F expansion. Well, can we talk more about how the sort of active fund management or mutual fund industry feels about e t F s. Uh I gather not so positive necessarily probably not. I mean, if you're an active mutual fund, you've got to make a decision do I ride the gravy train? Because if you look at the fees, like you know, I look at my mom's statements sometimes and I'm just I'm stunned at how much she pays and the load she already

paid for mutual fund in a Class A share. So they're making so much more money than e t f s even though ETFs are growing, so it's a gravy train. Still they have to ask themselves, do I cannibalize myself to survive in the future. Do I just ride this until it's over? And you can see some are struggling with that question. PIMCO is a good example of one

that said, look, we've got to get involved. So they came in with active etf they've been somewhat successful, and then other companies have come in with smart beta versions of their active products. So a lot of these firms

are trying to figure that out. For sure, it's a big it's a big deal intellectually, I wonder so you you mentioned these different factors that people have discovered leads to outperformance, like momentum factors, so stocks that exhibit strong momentum tend to outperform, or sometimes people say value stocks or stocks with strong balance shoes, whatever it is. But well, these factors, like once it becomes so cheap to play

these strategies, do they cease to be useful? Like are people who for a long time have been investing these in these strategies worried that now that everyone can just press a button and instantly get momentum and that of having to say find it themselves will ruin the strategy itself. Sure, I think that is largely based on the herd mentality as well. You know, momentum. Everybody can make money by all piling into momentum stuff that's rights work. I see

it happened with low voltility all the time. Low ball has a big ear and then it has a bad year and then it has a big year in a bad year, and it kind of swings like a pendulum. And you actually know how ETFs trying to solve that problem, which is called multi factory t f s where they switch from the different factors based on market signals. So they got all, this is another strand on the smart

beta evolution line. And so yeah, people are concerned with which factor by using when, and but then generally like a dividend, DTF dividend is a factor that is something that just general retail investors like, they're not trying to time anything, they just want dividend. Little less vultility wouldn't scrifice a little upside. So some of these factors can actually be used in the long term, not just trying

to play it and beat the market. Let's go back to the very beginning of our story, because we had the sc SEE put out this report that somehow years down the line managed to spawn a huge, huge industry. And nowadays we see the SEC talking about e t f s in a slightly different light. Right, you've touched on it before. We've seen worries and concerns about e t f s. Uh, the liquid wrapper that might not

be suitable for all sorts of assets. Yeah. The the SEC has two main areas of focus where they literally have written rule proposals. I think that's the most important thing. One is on liquidity, right, so they've written some strict rules that e t s will have to be able to sell off a certain amount of assets that within fifteen days. That would affect how you'll bond. ETFs might have affected some emerging market funds. Uh, there's gonna be

some negotiations. Black Rock is lobbying them relentlessly, I'm sure, and so the final rule might not be as hardcore as the proposal. But that's one and then the other one is derivatives. They have a rule that would essentially limit the amount of leverage to one fifty, which would really at some leverage gts have a way to work around it, but largely that would inhibit a lot of three times, especially and maybe some of the two times.

And then beyond that are e t F where they move three x the underlying automatically, so you could buy a three x financial stocks one and if the banks rise one percent in a day, theoretically the e t F rises three percent that day. That's right. Every day that the three times doesn't work over the long term, but per day that that's what they promised. But the other two areas that they have looked at was one is August last year, which ironically was called Black Monday.

To right, it was referring to that as Black Monday, and uh e t f s were all involved in that, and that's why this whole Black Monday to Black Monday. It's kind of ironic, h that the e t F was designed to kind of counter one Black Monday, and there they are in the next one, right, because people are concerned about the ability of e t f s to actually function and track their underlying stocks and assets in an environment of intense volatility. August, though, can be

explained pretty easily. I've looked into it. It's really about the halting that the exchange has so on Black Monday, basically, market makers came in, stocks were halted, and if a market maker can't figure out the real time value and it needs all the stocks prices to figure that value out, it has to widen it spread on the e t F because it doesn't know where you are. The aps in as well, just just in order to protect themselves

from risks. So a market maker needs to know the actual real time, inter day net asset value of the stocks. And if all the stocks aren't having pricing because are halted, that's a chain reaction that makes it harder for e t F to trade. So if you look at Nastact that day, e t F traded fine because they didn't have the same halting rules that Nicey did, and Bondy TF traded fine that day because they weren't halted. So, in essence, August was a little bit of a complicated issue,

but certainly a concern. And then the other fourth area that SEC is concerned with is just complex products. We've described a little bit today, multi factor e t f s. They even brought up the millennial e t F which we uh, which you and I know about, that's designed to track stocks that theoretically millennials, as they get older

and spend more money, will do well. Eric, I guess the big question and I have, and maybe Joe has after listening to all of this, is do you think e t f s have been a net positive for investors or a net negative? Well, I'm a net positive. I've studied hedge funds, mutual funds and clothed and funds. I've been in fund data for fifteen years, and when I was assigned ETFs in two thousand and six, I quickly started to, you know, sniff around them, like, wow,

these things are really useful. They're they're fully funded and approved by the SEC N of the nine gives them some security. So I do think their net positive. I think I don't think any of the things that I just mentioned or the SEC is looking at, is really the thing I would be concerned with. I think a lot of that is um them reacting to media. Uh, there's some concerns there, But the big concern for me is I would feel the same way as Bogel does.

They trade eighteen trillion dollars a year, but they only have two trillion assets. That's n turnover. Put that in perspective. Stocks only turn over two d and fifty percent a year, so E t f s trade three times more. So when you trade, all you do is work over money to Wall Street. So I think that for investors, if they get hooked on trading too much, I think that's probably a losing scenario. So that would be my That would be maybe the net negative. Structurally, you'd say their

sound and they are low cost vehicles. But if the net result is it people get hooked on trading them, that undermines their benefit, is what you're saying, and that that's their choice. I just think if a retail investor starts trading, like we just talked about millennials loving the three x crude oil e T n H, then yeah, I think people could get hurt and that would leave a bad experience for that customer. We are like so into that. Thank you very much. Eric bolcons fascinating discussion.

Thank you so, Joe. We just learned a whole lot about the origins of e t f s. Would you think I thought it's fascinating. I mean it, guess when it comes to financial products, you just sort of take them for granted that they exist sometimes and you forget that someone had to invent them, someone had to design the mutual funds, someone had to design various structures of bonds that exist, and of course et f s are

no exception. And I love that it was discus ord in this gigantic SEC memo that was by mind numbing to the vast majority of the population. I really like the idea of the whole thing kind of coming full circle. We had them spring from this SEC memo, and now we see the SEC kind of worried that maybe the structure has been applied to things that aren't appropriate for it, right, like the idea in the beginning, Okay, we're gonna make this incredibly simple product. It's going to be good for

market stability, very low fees. And now you have these incredibly increasingly complex mutual funds, actively manage mutual funds, triple lever mutual funds, mutual funds where the underlying assets aren't particularly liquid, and now you have all these people like, oh what, what, where's this going? E t s for every single need you could possibly imagine, And it seems like the evolution of E t f s is not

slowing down anytime soon. So well, I have to check back in on this story in ten years and see where it is. Yeah, we will, And in the meantime, our listeners can go and read the full article over in Bloomberg Markets Magazine or on Bloomberg dot com. And Eric has a whole book coming out on E t F So if you really want to dive more into it, you should check out his book for sure. All Right, I'm Joe, Why isn't Thal? Thanks for listening to The Odd Lots Podcast. You can follow me on Twitter at

the Stalwart and I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and you can also follow Eric at Eric Balcunas. Thanks for listening.