Once upon a time in the distant land of Wall Street, there was a revolutionary investment tool called the ETF, or exchange-traded fund, to use its formal name. It started as a humble concept, a simple wrapper that allowed investors to gain exposure to assets organized according to an index. But little did anyone know that this unassuming innovation would go on to reshape the entire investment landscape.
As the years went by, the ETF industry experienced exponential growth. From its early days with a market cap of just $600 billion, it quickly ballooned to a staggering $3.6 trillion. The potential of ETFs seemed limitless, and projections were made about how big they could become. Some predicted $10 trillion in five years, while others dared to dream of $30 trillion by 2030.
This all began with the VIPERS funds coming online, which signaled to individual investors and a small but passionate class of Vanguard-focused advisors that ETFs are okay. After all, it’s hard for the Bogleheads to turn down a cheaper version of the random walk. And being anointed as a better mousetrap by somebody as visionary and profoundly credible as Jack Bogle opened the door for a huge rush into these products by core asset allocation advisors, which is what drove all the growth in the 2000s.
“So, there we are at Vanguard,” Bogle was later quoted as saying. “They looked at it. Many looked at it as a way to get into the brokerage business, which I thought was not catastrophic, but our original premise was to build a better mousetrap, and the world will beat a path to your door. And all of a sudden, we were out there hunting mice, as it were. And so, it didn’t warm my heart. I don’t recall feeling bothered about it, and I even, to be quite blunt about it, said, I’d probably have done it too.”
THE ACTIVE PIVOT
Soon after VIPERS came to market, PowerShares launched in 2003, and the PowerShares brand is where we first get the concept of smart beta ETFs in a big way. Bruce Bond, who’d previously been the head of marketing at Nuveen, led the launch. Bond says he’d seen all kinds of product packaging in the ETF space, and “you knew what the problems were for all the different products.”
“At the time, there were no active ETFs,” he remembers. “And I looked at it, and I said, well, what is an index? An index is a group of stocks that tracks something, right? And it doesn’t matter what it is.
“So, now there’s certain requirements an index has to have in order to be replicated by an ETF, but at the time, they were all benchmarks and just static, cap-weighted or dollar-weighted, however their weighting scheme was.
“But we looked at it and said, well, why wouldn’t we create an index of stocks that are intelligently selected using a quantitative methodology, and we will build an index out of A-stocks, A-ranked stocks, rather than just all stocks.
“And we’ll have it weighted, like the market, so it’ll look like the market from a weighting exposure standpoint, but we’ll do that with quality securities rather than just all securities. And that’s when the IntelliDex was born, and really intelligentindexing or smart beta.”
Going active started relatively modestly with the introduction of smart beta strategies. These innovative funds aimed to outperform traditional market-cap-weighted indices by utilizing quantitative methodologies and intelligent stock selection.
They reflected the index but did it via more efficient routes. Passive profile, active management. For an industry crawling out of the dot-com crash and mutual fund scandals, this was a faster way to get investors back on track.
Rob Arnott, a prominent advocate for smart beta, became the face of this movement, spreading the word about the benefits of intelligent indexing. However, not everyone was convinced that this growth was sustainable.
Skeptics worried about the overwhelming number of ETF options available to investors. They feared that too much variety would lead to confusion and poor investment decisions. But proponents argued that the evolution of ETFs was a natural progression, offering investors a wide array of choices and opportunities.
Another groundbreaking ETF that captured the imagination of investors was the Gold SPDR (GLD), which provided access to physical bullion as an asset class. ETFs are wrappers, right? The envelope is agnostic. You can wrap anything in it. What became wonderful is that people discovered that you could deposit gold into the envelope and issue shares that would each theoretically be a proxy for some fraction of that metal in the vault.
And then they did silver. And currencies. And all kinds of things. It scaled up and it scaled down. Someone with $20,000 couldn’t buy a meaningful amount of gold as part of a balanced asset allocation model. The storage fees would have eaten them alive.
Before GLD, gold was seen as a niche investment, accessible only to hedge funds, major institutions and people with a few collector coins in a locked box. After GLD, the average investor could pour $1 billion into the fund in the first three days it was open.
WHERE NOW?
As the ETF industry continues to expand, experts speculate on its future direction. Some believe that traditional active management will find its ultimate home within the ETF format, with companies such as Fidelity and T. Rowe Price utilizing their research teams to select ETFs for investors.
Dimensional Fund Advisors has ETFs now. So do Goldman Sachs, AllianceBernstein and other traditional mutual fund shops. Others predict the rise of AI-based and quant funds offering even more sophisticated strategies, a niche for everyone.
Despite the differing opinions, one thing remains clear: ETFs have become a powerful tool in an investor’s toolkit. They have revolutionized how people invest, providing access to various assets and strategies.
The ETF industry had grown far beyond anyone’s expectations, and its impact on the financial world has been undeniable.
As the story of ETFs has unfolded, it’s become evident that this humble investment tool has transformed into an entire industry. It has surpassed the expectations of its creators and even surprised the late Nathan Most, one of the pioneers of ETFs.
Fast forward to today, we see incredible innovations such as Volatility Shares leveraging VIX futures and single-stock ETFs such as the TREX family and the innovations GraniteShareshas pushed forward.
This is the future. It’s happening now. Your clients can buy low-cost index funds without your help and take the random walk on their own. That’s not how you earn your fee. You earn your fee by navigating the far more complicated world of modern ETFs for them.
