Odd Lots - Episode 18: The Obscure Report That Spawned the ETF Industry

Episode Date: March 7, 2016

In 1987, investors watched in horror as the Dow Jones Industrial Average plunged 22 percent in an event that became known as "Black Monday." Months later, the U.S. Securities and Exchange Commission published an 840-page report into the incident; in it was buried a seed that would eventually sprout into the $3 trillion market for exchange-traded funds. Eric Balchunas, ETF analyst for Bloomberg, has the story of the stock exchange executives who seized upon an idea to create what is now one of the world's most pervasive financial products - and the investors who passed them up.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLOTS. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast, OddLLLLLOTS on Amazon Music. Hello and welcome to another edition of the OddLots podcast. I'm Joseph Wisenthal, managing editor, Bloomberg Markets. And I'm Tracy Allaway, executive editor of Bloomberg Markets. So Tracy, today we're going to be, it's like a special episode. We're talking to one of our colleagues here at Bloomberg. A special edition of AdLot. We're going to be talking to. about one of the most important financial innovations of the modern era, wouldn't you say? I would definitely say so. Isn't it something like a $3 trillion industry? Is that right? And that industry is the ETF. And I think almost everybody at this point who's aware of markets

knows what ETFs are. They're exchange-treated funds. You can use them to make a bet on the S&P as a whole. You can use them to make a bet on gold. And you can use them to make a bet on gold. And you can use them to do crazy stuff like make a 3x levered bet on junior gold miners. I do that all the time. Yeah, of course. But it's like a basket of things, right? And it trades like a single stock on an exchange. Exactly right. And these ETFs 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 ETFs all the time.

From what humble beginnings did the ETF market come to us? This is the fascinating thing we're going to discuss with our colleague, Eric Bacunas. He has a new article out in Bloomberg Markets Magazine called The ETF 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 ETF, 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. An 840-page government report is really where the seed for the ETF was found. So what happened was in the 87 crash called Black Monday, right? 1987. 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.

Wait, can you 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 arbitraging the futures to the individual stocks, which involved buying the futures and then selling all 500 or how many of 100 stocks at the same time.

Right. So what happened was those program traders stepped in and they were putting all the sell orders on the individual stocks. That caused more panic. And 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 508 point drop 22% in one day. Wow. 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, in just about any area. That's right. Yeah. Okay. So the SEC put out after several months of studying that crash in 1987, they wrote an 840-page memo. And what was in that memo that led to the ETF? Sure.

On chapter three, deep into the actual white paper memo, there was something where they talked about if an alternative approach were to be examined. And so they use that language. And what they were 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 500 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 as maybe a possible alternative approach.

However, they did use the word product. And then the two guys at the Amex, 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 proposal from the SEC. I mean, it's kind of a creative approach, right? To read an SEC 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 Amex, 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 840 page government report? But they did and 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, Amex, 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 or she who reads an 840 page government white paper and really notices all the details. There is a reward to that. They deserve to make money. Yeah, exactly. I think so. That's cool. 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 Bogle at Vanguard and see if they could trade an S&P index fund from Vanguard. Jack Bogle met with Nate Most, who Nate Most and Steve Bloom were the two guys. And basically said, thank you, but no thank you. And when I interviewed Jack Bogle, 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 feel, fix him might be better. So that's what Bogle claims. So basically he said, no thank you because Jack Bogle 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 lied. So Nate Most said that that meeting got him thinking about a way where you could trade a fund, but not drive up costs in 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 and the Amex came in to make the ETF more than what the SEC called for. And that is that Nate Most was 74 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 cocoa, 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 that 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 ETF structure. So let's just break down to what we've learned because I think this is really fascinating. For those who don't know, Jack Bogle famous for his belief in indexing, not trading, the key to winning in investments is low costs. And so theoretically, something like an S&P index fund could have appealed to him. when he saw this product, he said, A, this is a trading vehicle.

He's not into vehicles that make it easy to get in and out of the market. And B, 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 Bogle, 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 ETFs can trade upwards of $18 trillion a year. They trade all day long, right? And if you look at like SPY, for example, trades about $25 billion a day. That's the big S&P 500. That's the big S&P. That's the big S&P. That's the one that they first designed these two guys. But yet someone like my aunt Joyce could go into the S&PY for 10 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 their proposal come in from Amex with this design, he was blown away. It was way more than he thought when they were writing it. So he thought this product 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 borrow 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's no warehouse, right? So instead of a warehouse, it's called a custodian. So State Street was one of the first obvious places they went. And so that became the custodian for the stock. So the custodian is the virtual warehouse that, and today, every ETF needs a custodian to store those stocks or bonds or whatever it's holding. and that is what makes the ETF slightly different than a derivative. Some people say ETFs are a type of derivative. The fact is that these stocks that are in the SBY or any ETF are, you can picture them. They're literally stored in a warehouse just happens to be a custodian. It's electronic. But the fact is, those are receipts for those physically, they're physically backed. And 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 each. Right? Sure. It's called the creation redemption process. And this is where I sometimes teach courses on ETS where the students get really like confused and bored. I'll be honest. That's why our listeners are not going to get. Our listeners are very sophisticated, wonky people. And this is the part they're going to be most excited about. So okay. Explain it to us. Well, and that's why I went into the story of how the first ETF 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, authorized participant which is a gigantic bank connected to the system with you know a lot of money basically they are every ETF has several APs that are

assigned to it when a new creation is done the AP will hand in the basket which is say the 500 stocks in the S&P into the state into the issuer State Street and in return they get 50,000 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 SPS SPY shares, hand them into State Street and get their 500 stocks back. And then that is sort of the creation of an impure 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

ETF 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 APs to bring their shares and things to this warehouse and get the sort of the ETF 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 ETFs because if the basket, if the stocks, if the ETF price starts to go a little higher than the value of the 500 stocks, the AP can arbitrage by handing in the ETF shares and buying the underlines or vice versa. So they can always arbitrage the ETF versus the basket by using the creation redemption process. That, in effect, is a natural economic motive for them to keep the price close to the NAV.

And that's a huge difference on ETFs compared to closed-end funds, which don't have that ability to create and redeem new shares any time because closed-end funds are limited shares outstanding. So there's always massive premiums or discounts. That is one sort of way the ETF evolved, the closed-end fund to 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 ETF, I'm going to 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 AP, 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 that 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 story. So now we understand we have this, the SPY, which still trading the gigantic S&P 500 index fund. They launch it. How did it go? How did they do what attracting people to 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 is it had to go through the 1940 Act, which is the strictest of regulations.

So it finally got approval under the 1940 Act. That's what regulates mutual funds. So when it came out in 93, it had a good first day. They had a lot of hype. They had a large spider hanging from the ceiling. And it traded a million shares. But a spider because? Well, because they're called the Standard and Poor's Depository Receipts with acronym Spiders. So that's a nickname spider. Spiders. And back to the commodity warehouse receipts, depository receipts is even in the name of Spider, which kind of connects to the commodities warehouse receipt. 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 guerrilla marketing. When it really came back, after like two years, they were almost thinking of closing it. It traded 18,000 shares one day, about five months after launching. which is that's like less than the Global X solar energy ETF trades today. So it was not trading at 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 90s kicked in. 1995 was like an epic year for the market.

So just buying the S&P 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-90s, 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 90s 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-90s. 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 adopters were big institutions because some of the institutions like using it in place. Wait, I feel stupid. Who is the investor? I think it's Bill Gates, but he wouldn't tell me. Oh.

I'm just thinking. But they think that he was into them for his personal investments. Yes. Interesting. Yeah. But we don't know that person. We don't know. That's just what people speculate.

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 wasn't that rich yet. I don't think he was from Seattle. 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 SPY ETF is trading like 25 billion worth of shares a day. But beyond just the story of that particular ETF, we've also had the entire industry kind of grow around it. We have all these new kinds of ETFs. 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 80s, 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.

GLD was a game changer. That was the first commodities ETF. Now you've got 150 commodities ETFs. Fixed income, as you know, we've got 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 hold total return swaps or oil futures that hold, you know, literally hold futures contracts. And now you're basically buying an ETF that is like your personal oil futures trader. So they've expanded into every asset class in what I call standardization, just like a UBS port or a gas. pump has standardized, you know, that need for consumers. The ETF 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 ETFs, I think of something really simple, like S&P, gold, but something sort of underlying is passive. But increasingly,

the composition changes and their active ETS. and their ETFs based on formulas 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, you know, whatever, 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 $400 billion section of the ETF world. And that is where you're getting a lot of the new players like Goldman Sachs and J.P. Morgan.

They think smart beta is the future because there's $10 trillion in active mutual funds right now. And a lot of that money is going to go away because of 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 capital gains taxes either. So smart beta ETFs are, in some people's eyes, a real interesting arm of the ETF expansion. Well, can we talk more about how the sort of active fund management or mutual fund industry

feels about ETFs? 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 statement sometimes, and I'm just stunned at how much she pays and the load she already paid for a mutual fund in a class A share. So they're making so much more money than ETFs, even though ETFs are growing.

So it's a gravy train still. So 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. Pimpco is a good example of one that said, look, We've got to get involved. So they came in with active ETFs. 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 deal. Intellectually, I wonder, so you mentioned these different factors that people have discovered lead 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 will 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 in these strategies worried that now that everyone can just press a button and instantly get momentum instead 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. So not everybody can make money by all piling into momentum stuff. That's right. I mean it cease to work. I see it happen with low volatility all the time.

Lowell has a big year and then it has a bad year. And then it has a big year and a bad year. And it kind of swings like a pendulum. And you actually know how the ETFs trying to solve that problem, which is called multifactor ETFs 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 I use and when. But then generally like a dividend, ETF, dividend is a factor.

That is something that just general retail investors like. They're not trying to time anything. They just want dividend, a little less volatility. They wouldn't sacrifice 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 SEC 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 ETFs in a slightly different light, right? You've touched on it before.

We've seen worries and concerns about ETFs, the liquid wrapper, that might not be suitable for all sorts of assets. Yeah, 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 ETFs will have to be able to sell up a certain amount of assets within 15. within 15 days. That would affect high-eel bond ETFs. It might even affect some emerging market funds. There's going to be some negotiations. BlackRock is lobbying them relentlessly, I'm sure. And so the final rule might not be as hardcore as their 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 150, which would really some leverage ETFs have a way to work around it. But largely that would inhibit a lot of the three times, especially, and maybe some of the two times. And then beyond that... These are ETFs where they move 3X the underlying automatically. So you could buy a 3x financial stocks one. And if the banks rise 1% in the day, theoretically the ETF rises 3% that day. That's right. Every day.

The three times doesn't work over the long term, but per day, that's what they promise. But the other two areas that they have looked at was one is August 24th of last year, which ironically was called Black Monday too, right? Everybody was referring to that as Black Monday. And ETFs were all involved in that. And that's why this whole Black Monday to Black Monday, it's kind of ironic that the ETF 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 ETFs to actually function and track their underlying stocks and assets in an environment of intense volatility.

August 24th, 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 stock's prices to figure that value out, it has to widen its spread on the ETF because it doesn't know where it is.

To lure the APs in as well? Just in order to protect themselves from risk. So a market maker needs to know the actual real-time intraday net asset value of the stocks. And if all the stocks aren't having pricing because they're halted, that's a chain reaction that makes it harder for ETFs to trade. So if you look at NASDAQ that day, ETFs traded fine because they didn't have the same halting rules that NICD did. And Bond ETS traded fine that day because they weren't halted. So in essence, August 24th 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, multifactor ETFs. They even brought up the millennial ETF, which you and I know about very well. So that's an ETF that's designed to track stocks that theoretically millennials as they get older and spend more money, we'll do well. Eric, I guess the big question I have and maybe Joe has after listening to all of this is, do you think ETFs 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 closed-in funds. I've been in fund data for 15 years. And when I was assigned ETFs in 2006, I quickly started to sniff around them. Like, wow, these things are really useful. They're fully funded and approved by

the SEC under the 1940 Act gives them some security. So I do think they're a 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 them reacting to media. There's some concerns there. But the big concern for me is I would feel the same way as Bogle does. They trade $18 trillion a year, but they only have $2 trillion in assets. That's 900% turnover. Put that in perspective, stocks only turn over 250% a year. So ETFs trade three times more. So, you When you trade, all you do is fork 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 maybe the net negative. So structurally, you'd say they're 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. Yeah. And that's their choice. I just think if a retail investor starts trading like we just talked about millennials loving the 3x crude oil ETN, then yeah, I think people could hurt and that would leave a bad experience for that customer. We are like so into that

millennial ETN. Thank you very much, Eric Belcuna's fascinating discussion. Thank you. So, Joe, we just learned a whole lot about the origins of ETFs. What'd you think? I thought it was fascinating. I mean, I 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. Right. Someone had to design the mutual fund. Someone had to design various structures of that exist. And of course, ETFs are no exception. And I love that it was discovered in this gigantic filing SEC memo that was probably 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 going to 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 managed mutual funds, triple levered mutual funds, mutual funds where the underlying assets aren't particularly liquid. And now you have all these people like, oh, where's this going? ETFs for every single need you could possibly imagine. And it seems like the evolution of ETFs is not slowing down anytime soon. So we'll have to

check back in on this story in 10 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.com. And Eric has a whole book coming out on ETF. So if you really want to dive more into it, you should check out his book. For sure. All right, I'm Joe Wisenthall. Thanks for listening to the Adlots podcast. You can follow me on Twitter at the stalwart. And I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway, and you can also follow Eric at Eric Balcunis. Thanks for listening. The news doesn't stop on the weekends.

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