A Brief History of the ETF

By John C. Bogle

When I first studied the mutual fund industry six decades ago, I was struck by the promise of “daily liquidity.” Investors could liquidate their share of the funds they owned each day, essentially at an asset value determined at the subsequent close of business. I thought such a promise was remarkable, and it was honored almost without exception during the ensuing 60 years. Daily liquidity, along with professional management, diversification, convenience, and shareholder service were the keys to the fund industry’s enormous growth, which took place largely during the great bull market of 1982-1999. Fund industry assets soared from $2.5 billion in mutual fund assets when I joined the industry in 1951, to more than $6 trillion in 2000. While asset growth then slowed, it continued at a more reasonable 6 percent rate; with assets approaching $13 trillion as 2013 begins.

Early in 1992, a visitor came into my office in Valley Forge, Pennsylvania, and tried to persuade me that the daily liquidity we offered for our index funds was not nearly good enough. He presented a design for a new “product” in which shares of the Vanguard 500 Index Fund could be traded instantaneously throughout the market day, and proposed that we partner with him. He was convinced that if Vanguard Index 500 shares could be traded on the nation’s stock exchanges just like individual stocks, it would vastly increase our client base by attracting a new breed of investors. (Of course, it would also attract speculators, though he did not use the word.)

Think of it, he said: in addition to the diversification, the portfolio transparency, and the low expense ratios that Vanguard already offered, investors would gain the ability to sell shares short or buy them on margin; to trade easily on foreign exchanges; possibly to enhance tax efficiency; and to attract hedge funds and other institutional investors by enabling them to fine-tune their risk exposures on a moment-by moment basis. My visitor, soft-spoken though he was, was clearly a missionary for his concept.

His name was Nathan Most, and he was head of product development at the American Stock Exchange. He laid before me a plan for a breakthrough innovation that would become known as the exchange-traded mutual fund. I listened to his presentation with interest and gave him my reactions: (1) there were three or four flaws in the design that would have to be corrected in order for the idea to actually function; and (2) even if the new design solved the problems, our Index 500 Fund was designed for long-horizon investors. I feared that adding all that extra liquidity would attract largely short-horizon speculators whose interests would ill-serve the interests of the long-term investors in our index fund. So, we found no community of interest. But we parted amicably, and would enjoy a nice friendship over the years that followed.

As Nate Most told the story, on his train ride back to New York City he figured out how to fix the operational problems that I had found in his design. He then resumed his search for a partner, soon finding one at giant State Street Global Advisers. In January 1993, State Street introduced the Standard & Poor’s Depository Receipts. The “SPDRs,” based on the S&P 500 Index, have dominated the ETF marketplace ever since. Despite the amazing influx of new ETFs, year after year, the SPDRs remain the world’s largest exchange-traded fund—and now the world’s most actively traded stock—with assets exceeding $120 billion.

ETF assets have grown, I’m certain, far beyond Nate’s highest expectations. With some $1.3 trillion now invested in ETFs, it is without hesitation that I describe Nathan Most’s visionary creation of the first ETF as the most successful marketing idea of the modern age of the securities business. Whether it proves to be the most successful investment idea of the age, however, remains to be seen. I have my doubts. So far, ETFs, in general, have not served their investors well. Indeed, how could ETFs possibly serve investors well? With over 1,400 ETFs—tracking an incredible 1,112 indexes(!)—picking an ETF is just like picking a stock, with all of the attendant risks. (I freely concede that speculating in index funds generally carries significantly less risk than speculating in individual stocks.)

So, it’s hard for me to imagine that today’s ETFs will become the Holy Grail of investing—that ever-sought after way to beat the returns of the stock market. Yes, some ETFs offer the temptation to bet on narrow segments of the stock market, some now employ exotic leveraged strategies, and some make betting on commodities relatively easy. But six decades of investment experience have reinforced my basic tenet that short-term trading—yes, let’s call it speculation—is by definition a loser’s game, and long-term investing is by definition a winner’s game.

“. . . All Day Long, in Real Time.”

The early advertisements for the SPDR expressed its marketing proposition bluntly: “Now, you can trade the S&P 500 Index all day long, in real time.” I can’t help but wonder, if you’ll forgive the coarse language, “What kind of a nut would do that?” Yet day after day, the SPDR lives up to its promise—invariably the most actively traded stock in the entire world, with average daily trading volume of 144 million shares, or an astonishing $5.1 trillion in 2012 alone. With SPDR assets averaging about $110 billion for the year, that’s a turnover rate of 4,688percent. I concede the success of the ad’s message: Investors are indeed trading the S&P 500 Index all day long in real time—in huge amounts, and in unimaginable volumes. Nate Most, I think, would be proud that his dream has been realized.

But the SPDR has spawned a whole host of followers, and the diversity of investment options seems to have reached far beyond the furthest reaches of what even an innovator like Most would have found appropriate. “Name an exotic product—any product you can imagine—and we’ll create it,” is the war cry of the new breed of ETF entrepreneur. These marketers are in the game, not necessarily because their so-called “product” may be good for investors, but because they may hit the jackpot, attract a lot of assets, and make a personal fortune. Some ETFs, used properly, are good for investors, while others are not. But the temptation for fund marketers to jump on the bandwagon of a hot new product is almost irresistible. During my career, I’ve seen scores of innovations, but I know of only a handful that has served the enduring needs of long-term investors. And ETFs hardly meet that standard.

 

John C. Bogle (Bryn Mawr, PA) is Founder of The Vanguard Group, Inc., and President of the Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as Chairman and Chief Executive Officer until 1996 and Senior Chairman until 2000. He had been associated with a predecessor company since 1951, immediately following his graduation from Princeton University, magna cum laude in Economics. The Vanguard Group is one of the two largest mutual fund organizations in the world. Headquartered in Malvern, Pennsylvania, Vanguard comprises more than 100 mutual funds with current assets totaling about $742 billion. Vanguard 500 Index Fund, the largest fund in the group, was founded by Mr. Bogle in 1975. In 2004, TIME magazine named Mr. Bogle as one of the world's 100 most powerful and influential people, and Institutional Investor presented him with its Lifetime Achievement Award. In 1999, FORTUNE designated him as one of the investment industry's four "Giants of the 20th Century." In the same year, he received the Woodrow Wilson Award from Princeton University for distinguished achievement in the nation's service."

 

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