New Financial Instruments and Institutions: Opportunities and Policy Challenges

Chapter 7: The Development of Improved Exchange-Traded Funds in the United States

193 The Development of Improved Exchange-Traded Funds in the United States 7 Many of mankind’s great ideas owe at least some of their success to serendipity. A popular legend suggests how serendipity helped mankind learn the usefulness of fire. When one of our ancestors came upon the site of a fire that had been started by lightning, this early human discovered that an animal’s carcass had been burned by the fire. The “cooked” meat tasted better than raw meat. This kind of serendipity has been a common theme in many of mankind’s innovations. The Introduction of ETFs—Something to Trade on the American Stock Exchange One of the best examples of serendipity in the financial markets—from several angles—is the early development of exchange-traded funds (ETFs). In attributing some features of exchange-traded funds to serendipity, we certainly do not mean to minimize the role of the developers of the early versions of these funds. They deserve full credit for the wisdom they displayed in designing the ETFs introduced in Canada and the United States. Our focus is on the interaction of serendipity and financial engineering in the development of some important elements of the structure of exchange-traded funds. Some key features became part of the ETF almost by accident, but they are so important that they serve as the basis for revolutionary financial engineering to reshape the U.S. fund industry. todd j. broms gary l. gastineau We have described the early history of ETFs elsewhere, so this description will be brief.1 The first viable open-end exchange-traded fund was developed in Canada and began trading in 1989 as the Toronto Stock Exchange Index Participations (TIPs). It took four more years for the American Stock Exchange to launch the SPDR, the first open-end ETF in the United States. The American Stock Exchange (AMEX) has always operated in the shadow of other markets, principally the New York Stock Exchange. The original name for the American Stock Exchange was the New York Curb Exchange. The name comes from the fact that the exchange’s early traders made informal markets standing on the sidewalk and in the street at the corner of Broad Street and Exchange Place outside the New York Stock Exchange. That corner is now occupied by a security guard’s station for the New York Stock Exchange, a very different kind of security activity. “The curbstone brokers were always the have-nots, excluded from the privileges and information of the formal exchanges, but instrumental in forcing the evolution of efficient markets as the system moved from auction to pits to specialist to computers and continuous markets.”2 After it moved indoors in 1921, the AMEX grew and sometimes prospered by developing and embracing new products to trade. By far, the most significant and most successful of the products introduced to U.S. investors by the AMEX is the exchange-traded fund. The labels exchange-traded fund and ETF are applied to a number of financial instruments. The fact that investors can trade most of the products called ETFs throughout the day at market-determined prices that are very close to the intraday value of an underlying portfolio or index is one common feature of these securities. To the best of our knowledge, the term exchange-traded fund was first used by Nuveen Investments to refer to its closed-end funds a number of years before the S&P 500 SPDR appeared in the United States in 1993. Many socalled ETFs are not funds or even investment companies—as defined by the Investment Company Act of 1940. The ETF label has been attached to some open-end structured notes and to a number of trust products including HOLDRs and various instruments based on currencies and commodities. Vanguard offers classes of exchange-traded shares of a number of its mutual funds. Vanguard calls these shares ETFs, but these share classes do not have some important features that characterize the ETFs descended from the original SPDR. The open-end ETFs based on the SPDR model have a number of specific features that will be fundamental characteristics of a new generation of funds. These 194 todd j. broms and gary l. gastineau 1. See Gastineau (2001, 2002c, pp. 31–54). 2. See the chapter “The Kerb (1921)” in Sharp (1989, pp. 193–96). open-end ETFs do not have shareholder accounting...