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1. ETF historic profile
1.1. The efficient market theory
With the studies on market efficiency of Eugene Fama in the middle of the 60s, was born the
interest in instruments that replicate the market trend.
In his Ph.D. thesis, he explained that the major markets are efficient, or in other terms that the
prices reflect the information available.
In his considerations he distinguishes between three efficiency forms:
• Weak form: when the prices reflect the information embedded in the series of past
prices;
• Semi-strong form: when the prices, in addition to the series of past prices, reflect all
the public information (for example dividends or earnings);
• Strong form: when the prices reflect all the information, also the private one.
This view means that, on average, it is not possible to over-perform the market. In fact, it is
not possible to take advantage from the strategies of market timing and stock picking, because
all the information is incorporated instantaneously in the prices. For these reasons technical
and fundamental analyses are unhelpful.
The technical analysis looks at past information to foresee the futures prices. It is based on the
belief of the cyclical nature of the events: by studying the past observations, it is possible to
predict the future trends and to obtain a profit. But if the prices reflect the past information,
like in the weak efficiency form, it is evident that this type of analysis is absolutely useless,
because the prices already consider this type of information.
The fundamental analysis studies the intrinsic value of the stocks and tries to take advantage
of the securities that are mis-priced. This is possible only if the prices do not reflect all the
public information available and it is wrong for the market in semi-strong form, as Fama
sustains.
These considerations lead to the conclusion that, on average, an investor cannot obtain better
results than the market and increase the interest in financial instruments that follow the
market’s performances.
To explain the concept in mathematical terms, Fama himself writes:
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“market efficiency requires that in setting the prices of securities at any time t - 1,
the market correctly uses all available information.(…) Market efficiency then
requires that in setting prices at t - 1, the market correctly uses all available
information to assess the joint distribution of prices at t. Formally, in an efficient
market:
f (P
t
| Φ
t-1
) = f
m
(P
t
| Φ
m
t-1
)
• P
t
= (p
1
, ... .p
nt
) is the vector of prices of securities at time t,
• Φ
t-1
is the set of information available at t - 1
• Φ
m
t-1
is the set of information used by the market
• f
m
(P
t
| Φ
m
t-1
) is the market assessed density function for PV
• f (P
t
| Φ
t-1
) is the true density function implied by t-1.”
1
It is evident that, based on these considerations, the passive strategy becomes very attractive
and an instrument that simply replicates the trend of an exchange appears a good investment.
For this reason, the demand for financial instruments that follow a target index increased a lot
starting from the 70ies in advance.
1.2. The Portfolio trading
In the same years, was born the idea of managing an entire portfolio as a single stock, that
was concretized in the so called “portfolio trading”.
This strategy consisted in a method that allowed trading an entire portfolio as it was a single
security on the market. It is evident that, if a portfolio is traded in a unique deal, it has much
less costs than buying or selling many singles stocks, both in terms of commissions and time.
The interest in the portfolio trading was extremely high, but not all the investors had access to
this opportunity at the starting point.
1
Eugene F. Fama, (1976) Efficient Capital Markets: Reply, The Journal of Finance, Vol. 31, No. 1, pp. 143-145
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When the firsts portfolio trading were performed, in the 70s, they were exclusively addressed
to institutional investors with big portfolio to trade, because electronic systems were not
diffused and the cost to perform it was quite high. It was not possible to carry out the activity
on large scale.
Only with the computerization of the financial markets, the portfolio trading became cheaper
and accessible to all investors, but, until that, the growing interest in the concept of trading a
portfolio as a single stock pushed the research of other vehicles that allowed people to achieve
the same results. This led to the creation of a series of interesting financial instruments that
culminated in the birth of the ETFs.
1.3. The firsts primitive forms of ETF
In 1971 the first indexed fund was created by Wells Fargo, with $6 million of capital taken
from the pension fund of the Samsonite Corporation, that was addressed only to the
institutional investors. The strategy of the fund was based on an equal-weighted index of the
1500 New York Stock Exchange equities, but it was replaced in 1976 with a strategy based on
market weighted S&P 500 index. In the same year, John Bogle created the indexed funds
called “First index investment trust” (today is known as “Vanguard 500 index fund”) that
replicated the S&P 500 and was addressed to private investors. This fund was attractive
because it had very low commissions and fiscal efficiency higher than the other instruments
on the market. Its annual performance was very good, better than the results of the majority
part of the active funds.
Only in 1989 appeared the first financial instruments addressed to retail investors, the CIPS,
Cash Index Participations traded on the Philadelphia Stock Exchange, the EIPS and VIPS,
Equity and Value Index Participations Shares on the American Stock Exchange.
The IPSs tried to replicate the most famous indexes, S&P500 or S&P100, and were traded on
the markets like a stock. Their structure is very similar to futures, in fact for each long
position there was a short one, but they were margined and collateralized like stocks. For this
reason, the Chicago Mercantile Exchange sustained that they were futures and had to be
traded on future exchanges regulated by the Commodity Futures Trading Commission. The
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federal court declared the IPS as futures and illegally traded on normal markets, so the
investors were forced to liquidate their position on them.
In Canada in the same period appeared the TIPS, Toronto Index Participation Shares, that
replicated the TSE-35 and in a second time the TSE-100. It was not like the IPS because they
were units of a fund composed from the shares of the 35 (or 100) companies of the Toronto
Stock Exchange 35 (or 100). It had a very low total expense ratio due to the lending of the
shares in portfolio for a commission, but was costly for the market that was unable to recover
the expenses.
Another attempt was the Supershares and SuperTrust that were a mix of a trust and a mutual
funds, with a structure very complex and consisted in a portfolio of securities completely
collateralized. Due to the extreme complexity, these instruments were never traded on the
markets.
After these failed attempts, in 1990 was concluded the approval process of a financial
instrument that would satisfy the requests of simple replication of an Exchange and trading a
basket as a single stock.
1.4. The birth of the ETF
1.4.1. Standard and Poor Depositary Receipts
In 1993, on 22
nd
of January, the first Exchange Traded Fund appeared on the market, it was
the Standard and Poor Depositary Receipts, better known today as “Spider”, which replicated
the S&P 500 index. Also if the approval process ended in 1990, there were many other
obstacles to overcome before being traded on the American Stock Exchange, both regulatory
and logistic, especially because nobody knew how to use these instruments. SPY had
immediately an enormous success, the first day about one million of shares traded hands, and
it has become the most popular ETF today. To give an idea of this growth, the figure 1 shows
the volume of SPDR from the inception date to 2006.
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Figure 1 - S&P 500 SPDR (SPY) Monthly Volume Chart from 1993 to 2006
Source: Trading ETFs: gaining an edge with technical analysis, Deron Wagner, Bloomber press, 2008
The SPDR is a fund indexed with low management costs and low commissions (initially
18,45 basis point, today decreased to 12) due to the passive strategy followed, that does not
require the work of specialists.
The structure of the SPDR is the Unit Investment Trust, slimmer and cheaper than a
traditional fund, in fact it does not have to maintain a board of directors, but, among its
features, it has a defined length of time (in fact the SPY will end on January 22
nd
2018). The
fund holds all the securities that compose the S&P 500 weighted as they are in the index, so
the trustee, that is the State Street Global Advisors, has only to manage the weights of the
shares that compose the portfolio to maintain them aligned to the benchmark.
Also the Spiders, like the other financial instruments, have a defect. It consists in the so called
“dividend drag” and it means that the dividends distributed by underling stock in the portfolio
are not immediately reinvested, but they are paid out by the fund only every three months. It
is evident that there is a lack in performance due to this delay in time. A study from Edwin J.
Elton calculates the loss due to this problem:
“Realizing that dividends are paid once a quarter and that dividends can occur any time over
the quarter, the investor loses the market rate of return for an average of one and a half
13
months. However, the loss is even greater than this since dividends are not paid to the holders
of Spiders for approximately one month after the ex-dividend date. This makes the
appropriate loss 2.5/12 of the annual return. During the time period of this study, the rate of
return on the S&P Index was about 22.2%. Thus the loss due to not reinvesting the dividends
on the underlying stock in the index at the time they were received was approximately 10.2
basis points. This is very close to our direct estimate of 9.95 basis points obtained by
examining the underperformance of Spiders directly.”
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The study reveals that this problem is not to be underestimated and represents a huge
opportunity cost to take in account when investing in this instrument.
Despite the divided drag, the Spy is one of the most popular and traded ETF as shown in
Figure 2 and 3, that reports the first the average Asset Under Management and the second the
average volume from 2011.06.28 to 2011.09.28 of the 25 most traded ETF.
Figure 2 - Average Asset Under Management, calculated from 2011.06.28 to 2011.09.28, of the most 25 traded
ETF
Source: ETF Database
2
Edwin J. Elton, Martin J. Gruber, George Comer, Kai Li; Spiders: Where Are the Bugs? The Journal of
Business, Vol. 75, No. 3 (July 2002), pp. 453-472
Average Asset Under Management of the 25 most traded ETFs
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
SPY
XLF
IWM
QQQ
EEM
FAS
SDS
VXX
SLV
EWJ
XLI
VWO
EFA
XLE
GLD
TZA
SSO
TNA
FXI
FAZ
EWZ
XLB
XLK
GDX
TBT
Billion
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Figure 3 - Average Daily Trading Volume, calculated from 2011.06.28 to 2011.09.28, of the most 25 traded ETF
Data source: ETF Database
Source: ETF Database
1.4.2. World Equity Benchmark Shares
In 1996 Barclays Global Investor launched a new type of ETF that replicates the MSCI
Indexes, with the name of WEBS, World Equity Benchmark Shares, which in a second
moment were recalled iShares MSCI series.
The importance of these instruments is due to the fact that they were the firsts ETFs that
allowed investing in foreign markets, in fact they were based on foreign stocks traded on US
markets, and for this reason, they had immediately a big success.
An other remarkable features is their structure: unlike SPDRs, iShares chose the form of
Open-End fund, that ensures more flexibility in the investments, in fact sometimes it is very
difficult and expensive to replicate exactly an Index buying all the stocks contained in it and
assigning the correct weights, and it is simpler to use a statistically representative basket of
stocks or derivatives instruments.
Average daily trading volume of the most 25 traded ETFs
0
50
100
150
200
250
300
350
SPY
XLF
IWM
QQQ
EEM
FAS
SDS
VXX
SLV
EWJ
XLI
VWO
EFA
XLE
GLD
TZA
SSO
TNA
FXI
FAZ
EWZ
XLB
XLK
GDX
TBT
Million
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