The History of ETFs: Perspectives from ETF Legends, Reggie Browne and Arlene Rockefeller

ETFs have grown fast, yet there are still some opponents of the structure. However, the general story by

ETF opponents has changed over the past 5 to 7 years.

Opponents of ETF growth have gone from discussing the following in 2010:

Can an ETF collapse?⁽¹⁾

…to something less intimidating:

OK, they can’t collapse, but they’re going to do worse than actively managed mutual funds in a downturn.⁽²⁾

If perception is the reality, then the shift in concern from apocalyptic to “simply bad” is progress for us in ETF land. Outside commentary is trending in a positive direction. And with the marketplace’s better understanding of ETFs, has come a larger adoption of ETFs by financial advisors. The proof of this statement is evidence in a recently published Cerulli report: advisor allocation to ETFs has gone from 7.8% of their portfolios in 2013, to 13.9% in 2017.

Arlene Rockefeller

Reggie Browne

To gain a deeper insight into the industry and where it may be heading, we interviewed two of the most influential personalities in the ETF business — Reggie Browne, head of Cantor Fitzgerald’s ETF trading desk, and Arlene Rockefeller, who worked in portfolio management at State Street for the launch of SPY.

We hope you enjoy the conversation, which is a follow up to a podcast we did with Reggie back in December. (Arlene will be on the podcast at some point as well).

The History of ETFs

ETFs are most often contrasted with mutual funds. But ETFs have another competitor: Futures.  As Arlene described it:

ETFs were a response to several needs for investors. One of them was that smaller investors didn’t want to deal with futures.

And to Reggie, the moment he realized ETFs were going to be a big business?

It wasn’t a specific trade. It was seeing the competition to futures, and customers using ETFs over them.

There are specific moments in rapidly growing industries that give some an insight that the market for a product is bigger than originally predicted. For example, with the computer industry, those moments were having (1) computers go from being purely a commercial business product to (2) a personal computer in everyone’s home to (3) a computer we carry in our pockets. Each of those moments caused everyone to recalculate the market size/scale.

For the ETF industry, Reggie put it best when he said the following:

Seeing the competition against futures was my first ‘a-ha’ moment. From there, there were different step moments for the ETF industry. Early on, it was the hedge fund community seeing the power. Then it was financial advisors. Now its different types of asset managers, like insurance companies, coming in and expanding the total addressable market. Every five years it seems there’s a new type.

And, as Arlene described it, this was no accident. What led to all these different types of investors’ interest in ETFs was built into the original design. ETFs were a response to several needs. The first, we already mentioned (smaller investors didn’t want to deal with futures), but there were other major reasons too:

A second reason was in response to the crash of ’87. Mutual funds offered broad exposure to the market, but with trades only available at the close, the problem of a rapidly plunging market was exacerbated as it caused investors to feel trapped.

Investors were stuck in on-the-close trades on a day when the market closed down 25%.  What was worse, many funds at the time were only open at month-end.  This meant that many institutional investors could not sell until the end of October.  This was a sore point particularly with 401K participants at the time.

A third reason was mutual funds would realize capital gains that were not always aligned with the actual gains of the individual investors, and resulted in taxes before the investors sold their shares in the fund.

The tax efficiency of ETFs is likely what has really turbocharged the growth of ETFs in investor portfolios. And, as Arlene laid out, the tax efficiency was there from the beginning. One thing ETFs have gained over the years is the best test available — the test of time.

ETFs are Battle-tested

The ETF industry was part of significant events all around the world. While often scary at the time, it paid off in the long run as it proved the viability and durability of the products.

Along this theme, I asked Reggie what his most memorable day was trading ETFs:

The moments after 9/11 were very memorable. I was trading ETFs at the American Stock Exchange then {the AMEX was a mere two blocks away from the WTC towers}. All the trading moved from the AMEX floor, to the NYSE floor. At the time, ETF trading was still done by a single specialist on the floor.

To make that point clear: for 9/11, human traders had to be physically moved from the AMEX to the NYSE so ETFs could continue to trade. With most of the trading now electronic, market makers in ETFs can trade from any computer they can hook up to.

And Reggie went on to describe how he can categorize the rise of ETFs through world events like the closing of the Greek Markets or the closing of the Egyptian markets. In both of those instances, US-listed ETFs with exposure to those markets were still trading. Initially, the reaction was that this was an issue to have a product that continued to trade while you weren’t able to trade the underlying stocks. But many came to see this second level of liquidity that ETFs provide as a great benefit as it gave you a way to hedge exposure to those markets until they reopened.

For example, when the Egypt stock market closed, if you owned Egyptian stocks directly, you could not buy or sell the stocks. The US-listed ETFs that had exposure to the Egyptian stock market, however, continued to trade. While the market pricing on the Egypt-exposed ETFs certainly became much more volatile, at least you could buy or sell the ETFs to hedge any positions you may have. If you owned the underlying stocks listed in Egypt, you were stuck sittings on your hands, whether you wanted to or not.

Arlene continued on this theme by saying:

Today, the ETF provides a wide variety of market exposures and increase portfolio managers flexibility.  They can be used by individual investors to gain broad market exposure, smart beta exposure or active management exposure.  They can also be used by professional portfolio managers for equity cash sweep and a low cost exposure to markets that are expensive to trade.

Many of these capabilities were not available to the average investor before the creation of ETFs. Like most tools, ETFs can be used for good or bad, but the democratization in investing they’ve provided is powerful. With inflows of $464 billion in ETFs versus $91 billion into mutual funds in 2017, it seems investors agree.

If the future of ETFs can be as bright as the past, we should be OK! Thank you to Arlene and Reggie for sharing your time and knowledge.