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The Birth of a New Asset Class: How The ETF Came To Be

Nate Most ETF Inventor

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“There are only two ways to live your life. One is as though nothing is a Miracle. The other is as though everything is a Miracle.” Albert Einstein

Problems at the AMEX

In the late 1980s and early 1990s the American Stock Exchange (AMEX) was steadily losing ground to the New York Stock Exchange and the Nasdaq Exchange.

In an effort to save the American Stock Exchange and keep it relevant, Nate Most, who had worked at the AMEX creating new financial products, knew it would take a miracle to turn around the exchange.

The Search for a Solution

Nate, a physicist by training, took it upon himself to find a way to create a product the AMEX could trade and generate a profit.

He was looking for something that would separate the AMEX from the other Exchanges and decided to attempt to create an entirely new asset class. And, it was truly an uphill battle.

The result of Most’s work was the invention of the Exchange Traded Fund, or ETF!

A Whole New Asset Class is Born – Due to one’s man’s persistence

He set out to create an instrument that would trade an entire basket of securities as easily as you would trade a single share of stock.

There were many roadblocks, doubters, and naysayers:

  • The AMEX’s own lawyers
  • The Securities and Exchange Commission gave multiple “nos”
  • Institutional investors
  • Even Jack Bogle, founder of Vanguard, was originally not in favor

But these challenges only made Nate Most, a former submariner in the Navy, more determined!

The result of Most’s unflappable dedication and persistence was the invention of the Exchange Traded Fund, or ETF! 

It took about 6 years before the very first ETF, The Standard & Poor’s Depository Receipts, better known as today’s SPDR(SPY) was introduced in 1993 through a collaboration with State Street Global Advisors.  Most was 79 years old.

The ETF will be only 30 years old in 2023.

Today over $400 billion is invested in the SPY, making it the most popular ETF!

What exactly is an ETF?

While the acronym is short for an “exchange traded fund”, let’s break that down and take a closer look.

“Exchange Traded” refers to the fact that ETFs trade on a stock exchange just like a regular stock, and the same order types apply, e.g., market order, limit order, stop-loss order, etc. But that is where the similarity ends.

NOTE: This post does NOT address Leveraged and Inverse ETFs, nor Single Stock ETFs, which are far more complex and represent much greater risk than the standard ETF. As in any investment, know what you are buying.

The Underlying Value

When a company issues stock, it issues a fixed number of shares and that number remains in effect until the company decide to issue more shares.

As a result, the price of a stock is driven by supply and demand. As more people choose to own a particular stock and there are more buyers than sellers, the price will increase to reflect the increased demand.

Demand or lack of it, is what moves markets.

The value of an ETF is based on the value of the underlying securities held in the portfolio of the ETF. As a result, the value of an ETF changes throughout the day as the value of the underlying shares change.

Liquidity Issues

Another important consideration is Liquidity.

A stock’s liquidity is determined by how easy it is the buy or sell the stock throughout the day.

Therefore, a stock’s daily average volume of shares traded throughout the day is considered a good indicator of its liquidity. The higher the average daily trading volume the greater liquidity and this suggests ease of buying or selling that stock.

ETF liquidity is just as important as a stock’s and for the same reasons.

Generally, the liquidity of an ETF is tightly related to the underlying assets in the ETFs portfolio and the ability of a broker to buy and sell those assets. For large ETFs this is not an issue.

Like stocks, lower trading volume and lower liquidity can mean difficulty buying or selling.

The Fund part of Exchange Traded Fund

Now let’s examine the “fund” portion of the ETF.

A fund is an investment vehicle with very specific rules created by a Fund Manager, that allows investors to pool their capital to invest in a “basket” of securities.

The goal is to provide greater management expertise, more diversification and lower cost than an investor might be able to obtain on their own.

An ETF is typically passively managed with very low cost vs. a Mutual Fund which is actively managed by a professional and therefore charges management fees.

ETFs have evolved over the years.

While many ETFs do focus on broad market exposure such as the S&P 500, there are a growing number of ETFs that focus on specific asset classes, such as small cap equities, high yield bonds and even emerging markets.

The Benefits

The bottom line is that ETFs offer a lot of benefits for the average investor. They include:

  • Diversification: ETF’s can provide access to a variety of asset classes, e.g. securities, fixed income, sectors, commodities, geographic regions, etc.
  • Transparency: An ETF investor can easily check and see exactly what securities the ETF is invested in at any time
  • Liquidity: An ETF can be bought or sold when ever the market is open
  • Cost: Management fees are generally lower than most other alternatives

In summary, ETFs are an important investment product. They should not be considered as an alternative to stocks, but a compliment. ETFs can help balance a portfolio, by offering additional diversity and stability.

ETFs may have started slow, but they are being created and added to the market place every day.

There are currently almost 3000 ETFs listed on the 3 major US exchange. New ETFs open up new investment opportunities for creative investing.

To Infinity and Beyond!Mutual Fund companies have started to convert certain funds to ETFs.

Jim Atkinson is the CEO of Guinness Atkinson, the very first company to convert two of its mutual funds to ETFs in March 2021.

In his interview with Will Schmitt of CityWire one year ago, Atkinson indicated this was the beginning of a trend in the Mutual Fund industry.

“You will find, over the last decade, monthly net flows in ETFs is 90% positive. You go look at the open-ended equity funds, you’re going to find the inverse. Everybody in the industry is aware of this, I mean, this is not some fancy insight that I came up with. It is clear that investors prefer ETFs.”

Atkinson described the transition a very complex undertaking with a great many details and will probably take years for companies to complete these conversions.

In 2022, JP Morgan, Franklin Templeton and others have started converting selected Mutual Funds to ETFs.

In the first half of 2022, 138 new ETFs were created and 51 new issuers are bringing ETFs to market.

The new high risk Leveraged and Inverse ETFs, as well as the Single Stock ETF (which does not contain a single stock!), will be discussed in a future post.

There are now about 3,000 ETFs, not including ETFs from Foreign Exchanges.

The NYSE has a special ETF website, podcast, YouTube and even an ETF TV show. www.nyse.com/etfs

So buckle your seat belts. The investing world continues to grow, create, bob and weave.

Wherever in Infinity Nate Most is, I am sure he is jumping for Joy. Way to go, Nate!   You changed the world of investing!

Whether it is an ETF or a stock the same rule applies. Know what you are buying!

Always Ride Your Winners and Cut Your Losses.

Want to know more about Nate Most?  See:  “How A Creative Physicist Dreamed Up And Created The ETF” by Adam Shell, Investor’s Business Daily, 2/17/2022  here.

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