Exchange traded funds

The phenomenal growth of exchange-traded funds is a frequent topic in the financial press. These funds, with assets more than doubling each year from 1995 through 2000, have been warmly embraced by most advocates of low-cost index funds. Vanguard, the leading advocate of index funds, has introduced an exchange-traded funds share class and plans to add exchange-traded share classes to a number of additional domestic index funds. Most of the press coverage has correctly noted the major advantages of exchange-traded funds, low expense ratios, intra-day trading and high tax efficiency with no material premiums or discounts to the funds intra-day net asset value. However, there is a fair degree of misunderstanding about how exchange-traded funds work, why the expense ratios tend to be low and how most of the funds manage to avoid significant capital gains distributions .

A BRIEF HISTORY OF EXCHANGE-TRADED FUNDS

Exchange-traded funds, referred to by friends and foes alike as ETFs, are outstanding examples of the evolution of new financial products. We begin by tracing the history of the exchange-traded funds antecedents, the proto-products that led to the current generation of exchange-traded funds and set the stage for products yet to come.

PORTFOLIO TRADING

The basic idea of trading an entire portfolio in a single transaction did not originate with the Toronto Stock Exchange Index Participations or Standard and Poor’s Depository Receipts, which are the earliest successful examples of the modern portfolio-traded-as-a-share structure. The idea originated with what has come to be known as portfolio trading or program trading. In the late 1970s and early 1980s program trading was then revolutionary ability to trade an entire portfolio, often a portfolio consisting of the entire Standard and Poors 500 stocks, with a single order placed at a major brokerage firm. Some modest advances in electronic order entry technology at the New York Stock Exchange and the Amex and the availability of large-order desks at some major investment banking firms made these early portfolio or program trades possible. At about the same time, the introduction of Standard and Poor’s 500 index futures contracts at the Chicago Mercantile Exchange provided an arbitrage link between the futures contracts and the traded portfolios of stocks. It even became possible, in a trade called an exchange of futures for physicals, to exchange a stock portfolio position, long or short, for a stock index futures position, long or short. The effect of these developments was to make portfolio trading either in cash or futures markets an attractive activity for many trading desks and for many institutional investors.

As a logical consequence of these developments affecting large investors, there arose interest one might even say insistent demand for a readily tradable portfolio or basket product for smaller institutions and the individual investor. Before the introduction of mini contracts, futures contracts were relatively large in notional size. Even with mini contracts, the variation margin requirements for carrying a futures contract are cumbersome and relatively expensive for a small investor. Perhaps even more important, there are approximately ten times as many securities salespeople as futures salespeople. The need for a security, i.e. Securities and Exchange Commission-regulated portfolio product that could be used by individual investors was apparent. One of the first such products introduced were the Index Participation Shares, known as IPS.

INDEX PARTICIPATION SHARES

The Index Participation Shares were a relatively simple, totally synthetic, proxy for the Standard and Poor’s 500 Index. While Index Participation Shares on other indexes were also available, Standard and Poors 500 Index Participation Shares were the most active. They began trading on the American Stock Exchange and the Philadelphia Stock Exchange in 1989. Index Participation Shares traded with a level of activity that showed significant public interest, in spite of a lawsuit by the Chicago Mercantile Exchange and the Commodity Futures Trading Commission, which charged that Index Participation Shares were futures contracts. As futures contracts, they would be required by law to trade on a futures exchange regulated by the Commodity Futures Trading Commission, not on a securities exchange. In spite of the cloud cast by this litigation, Index Participation Shares volume and open interest began to grow.

The Index Participation Shares were, candidly, much like a futures contract; but they were margined and collateralized like stocks. Like futures, there was a short for every long and a long for every short. Index Participation Shares were carried and cleared by the Options Clearing Corporation and they provided a returned essentially identical to the long or short return on the underlying shares in the index with an appropriate quarterly credit for dividends on the long side and a debit for dividends on the short side.

Alas, success eluded the Index Participation Shares. A federal court in Chicago found that the Index Participation Shares were indeed illegal futures contracts and had to be traded on a futures exchange if they were traded at all. The stock exchanges began to close down Index Participation Shares trading and investors were required to liquidate their Index Participation Shares positions in an orderly manner.

While a number of efforts to find a replacement product for Index Participation Shares that would pass muster as a security were underway in the United States, another effort achieved success first in Toronto. There, the Toronto Stock Exchange Index Participations were introduced.

TORONTO STOCK EXCHANGE INDEX PARTICIPATIONS

Toronto Stock Exchange Index Participations were a warehouse receipt-based instrument designed to track the Toronto Stock Exchange-35 index and a later product tracked the Toronto Stock Exchange-100 index as well. These products traded actively and attracted substantial investment from Canadians and from international indexing investors. Toronto Stock Exchange Index Participations were unique in their expense ratio. The ability of the trustee to loan out the stock in the Toronto Stock Exchange Index Participations portfolio and frequent demand for stock loans on shares of large companies in Canada led to what was, in effect, a negative expense ratio at times.

The Toronto Stock Exchange Index Participations were a victim of their own success. They proved costly for the exchange and for some of its members who were unable to recover their costs from investors. Early in 2000, the Toronto Stock Exchange decided to get out of the portfolio share business and Toronto Stock Exchange Index Participations were liquidated or rolled into a Barclays Global Investors 60 stock index share at the option of the Toronto Stock Exchange Index Participations holder. The Barclays Global Investors fund was relatively low cost, but not as low cost as the Toronto Stock Exchange Index Participations, so a large fraction of the Toronto Stock Exchange Index Participations shares were liquidated.

While the Toronto Stock Exchange Index Participations were flourishing in Toronto, two other portfolio share products were under development in the United States: Super shares and Standard and Poors Depository Receipts.