The first modern exchange-traded fund (ETF), the Spider, debuted on the American Stock Exchange — now part of the New York Stock Exchange (NYSE) — 25 years ago. This milestone for ETFs is the embodiment of the most impactful development to hit the markets in almost nine decades.
By any measure, the ETF has changed markets and investing in significant and mostly positive ways, and these changes will be with us for decades into the future. To back up that assertion, let’s review the facts in context.
{mosads}From 1993, the percentage of average daily share volume (ADV) of ETFs has grown from an almost imperceptible level to nearly 17 percent.
It is even higher for average daily dollar value of trading. The same applies to market value — ETFs weren’t even a rounding error in 1993, and today, the market capitalization of U.S. ETFs is about 17 percent of the total market capitalization of the U.S. stock market.
Why is this important and what does it really mean? To begin with, the explosion of ETFs as investment and trading vehicles is the clearest manifestation of the shift from active to passive investing (as I’ve said before, active is not going away, but, passive will continue to claim a greater share of investable dollars — here and abroad).
The continued growth of ETFs and passive investing has ramifications for corporate governance, capital formation and innovation and market structure.
We saw 160 Initial Public Offerings (IPOs) in 2017 and 275 new ETF launches. Clearly, Wall Street is focused first on creating new ETFs that reflect strategies and sectors they think will appeal to investors, instead of bringing traditional companies to market.
There is a downside to the launch of all these new ETFs — many won’t succeed. There is a fundamental truth on Wall Street: You can’t take a group of illiquid securities and put them in a wrapper and suddenly make them liquid. An ETF is only as liquid as its components.
The Index Industry Association (IIA) recently indicated that there are approximately 3 million indexes being published. Indexes are primarily ways to measure economic activity and most do not lend themselves to financial productization.
Due to the structure of index ETFs, fund companies are becoming the largest shareholders of companies in the underlying index. This ownership is concentrating in ways we haven’t seen before. In the past, individual investor holdings would be concentrated at a broker, but the individual investor still retained the right to vote the shares.
Individual investors owning ETFs do not vote the shares; the ETF sponsor does. Blackrock, State Street and Vanguard, through their ETF arms, are now major shareholders of many public companies, and they are not content to be passive about their investment.
They are engaging with boards on a variety of issues, although most of the current focus appears to be centered on board diversity. Even though a company has no choice with regards to its inclusion in an index, it still needs to integrate index investors into its investor relations plans.
The markets today are built for speed, and speed only works with liquid securities. ETF trading and the correlated trading in the underlying companies is a major focus of the exchanges. They want listings because listings mean that they are the primary market for closing volume and that drives data revenue.
The Chicago Board Options Exchange (CBOE) just received permission, over the strenuous protests of Nasdaq and NYSE, to create a closing process for stocks listed on those exchanges. This effort, designed to take ETF and individual stock trading volume, if successful, will further weaken the connection between listing and trading.
If we look back at market disruptions like the Flash Crash, it is clear that thinly traded ETFs (and stocks) don’t fare well in times of crisis. This is an unintended consequence of the prioritization on speed in our current market structure.
While Nasdaq, NYSE and CBOE all spend incredible amounts of energy and capital on their trading platforms, it is becoming increasingly clear that one market structure may not serve all securities.
As we celebrate the 25-year anniversary of SPY and the advent of ETFs, it is clear that investors, advisors, traders, market participants and exchanges have all reaped the benefit of these new passive products. This new investing landscape isn’t smooth and perfect by any means.
Despite the challenges that remain in the boardroom and in the halls of the regulators, there is no doubt that the advent of ETFs and index investing are changing the financial markets in the most comprehensive and far-reaching way since the Wall Street Crash of 1929.
John L. Jacobs is a distinguished policy fellow and executive director of the Center for Financial Markets and Policy at Georgetown University’s McDonough School of Business. He created QQQ (The Nasdaq-100 ETF) in 1999 and has spent over 30 years in Financial Services.