Part 2: The Evolution of ETFs Globally

Note: This is a 5-part series that covers the following areas

  • Part 1: An overview of the ETFs market globally
  • Part 2: Evolution of ETFs -1st -4th generation ETFs
  • Part 3: The Future of ETFs (post 2030)
  • Part 4: The Risks & Rewards associated with exotic ETFs
  • Part 5: An overview of African ETF Market-Challenges faced

Part 2: The Evolution of ETFs Globally

First-generation ETFs: Exchange-traded funds are the brainchild of the late Nathan Nate who was dubbed “commodities man.” He came up with the idea in the 1980s while heading new product development at the American Stock Exchange. At the time, investors who wanted access to the S&P 500 index had to use open-ended mutual funds, which are bought and sold at net asset value (NAV) and priced only once a day, after the close of trading. Most saw a market for an index fund that could be traded throughout the day and used his experience in the commodities industry to develop a mechanism to allow it. The solution was what he called a “creation unit” — essentially, a large basket of stocks that institutions can exchange for shares in the fund, similar to the receipts that a warehouse issues to owners of commodities stored there. ETFs are relatively inexpensive to run because only authorized participants (APs) — typically, large financial institutions — can create or redeem shares. As ETF shares are in-kind transaction products, no cash is needed to buy or sell them to the fund; because no taxable income is generated during the creation–redemption process (shares are exchanged for the basket of underlying securities), ETFs are more tax efficient than mutual funds. It took three years for Most to sell AMEX management on his idea and another three years for the Securities and Exchange Commission (SEC) to grant ETFs an exemption from the 1940 Act. In January 1993, AMEX launched the SPDR S&P 500 ETF Trust (SPY) — known as “Spider” for short — managed by State Street Global Advisors. Within a few years, other ETFs had appeared.

The first generation of ETFs were plain-vanilla indexing strategies that tracked the returns of a specific market index by holding all the securities in the index. But they weren’t without risk. ETF managers are required to actively rebalance their portfolios regardless of the volatility or liquidity of the market, making it almost impossible for them to track their benchmarks perfectly. To reduce a fund’s tracking error, an ETF manager may lend the underlying securities to hedge funds and other market participants looking to sell the stocks short, creating risk for the ETF investors if the counterparties were to default. First-generation ETFs often used index-linked notes and other derivatives for cash management activities like dividend payments, creating additional counterparty risk.

Exchange-traded products gained popularity because they targeted both institutional and retail demand for diversification coupled with lower investment and operating costs than traditional index mutual funds, which in the early 1990s had annual management fees as high as 2 percent. Institutional investors embraced ETFs because of the added advantage of easy settlement (compared with swaps), intraday trading capacity and reduced counterparty risk (again, compared with swaps). Retail investors flocked to these products thanks to their lower costs and the ease of trading them through online brokerage platforms.

Second-Generation ETFs: The mechanism used by first-generation ETFs worked well for large, liquid benchmarks like the S&P 500, but it was difficult to implement for indices whose underlying stocks were less liquid or more expensive to trade. As a result, by the mid-’90s, second-generation ETFs eased the requirement to hold the whole array of an index’s securities and instead focused on owning a representative selection that tracked as closely as possible the index’s returns. These ETFs typically use quantitative methods to determine the optimal portfolio to replicate an index’s performance and will often hold the securities that have the largest weights in the benchmark. This generation of ETFs targets low tracking error and low transaction costs.

Second-generation ETFs provided access to international equity markets and to very broad, diversified indices tracking entire economies. In 1996, iShares debuted international ETFs in America, including 17 different country funds spanning the globe from Canada to Japan.

Bond ETFs also developed under this paradigm, but for fixed income ETFs, the replication is a much less exact science. The ETF manager is unlikely to be able to access every bond in the underlying index. Instead, it creates a portfolio of bonds designed to track the duration, quality, maturity and exposure characteristics of the index within reasonably tight bounds. Some bond ETFs were constructed using short positions in various interest rate swaps hedged by long positions in high-yield bonds. Like their first-generation cousins, second-generation ETFs can experience counterparty credit risk if their managers engage in securities lending or use derivatives for cash management. And although second-generation ETFs attempt to closely mimic the performance of the target index, they are not immune to tracking error risk

Third-Generation ETFs: These track the S&P 500 and are naturally capitalization weighted and have Fama–French factor loadings (which show the relationship of different variables to the underlying Fama-French factors). Funds with different weighting schemes — equal weighted, revenue weighted, dividend weighted — started to appear on the landscape in the early 2000s. Their performance, risk and volatility profiles are different from cap-weighted ETFs because the varied weighting schemes are exposed to different factors, depending on their construction. Equal weighting, for example, will typically shift an ETF toward smaller companies, while dividend weighting will generally tilt it toward value stocks.

As the ETF industry developed, providers introduced many new products that were far from plain vanilla. These exchange-traded products (ETPs) employ a variety of different structures, including exchange-traded derivative contracts (ETDCs), exchange-traded commodities (ETCs) and ETNs. ETDCs are standardized derivatives contracts that trade on an exchange; many exotic ETF products use this structure. ETCs track the performance of commodities markets. Barclays Bank introduced ETNs in 2006 to allow retail investors to invest in commodities, currencies and other hard-to access markets. They are senior, unsecured, unsubordinated debt securities issued by a bank and listed on an exchange, and they can be either collateralized or uncollateralized. Credit risk is partially hedged for collateralized ETNs, but uncollateralized ETNs are fully exposed to counterparty risk.

These third-generation ETFs have one thing in common: They employ swaps or other derivatives to replicate the performance of an index rather than investing in its underlying securities. The manager of these synthetic ETFs typically replicates the index’s performance by entering into a swap contract with a financial institution, often a bank. The swap counterparty agrees to pay the index return, including dividends, to the ETF in exchange for a swap fee and the return on a basket of securities held by the ETF as collateral. The collateral securities do not have to be the same as the securities in the index (in fact, they often are not). This structure is known as an unfunded swap (Figure 1).

Unfunded Versus Funded Swap Model

Figure 1 : Source: JustETF.com

Synthetic ETFs can also be created using funded swaps. In a funded swap, the counterparty deposits the collateral securities with an independent trustee to hold on the ETF’s behalf. The collateral in that account is pledged to the ETF and is technically its property. The funded swap structure came into vogue in the wake of the global financial crisis to protect ETFs from the risk of their counterparties going bankrupt.

Proponents of synthetic ETFs claim the funds do a better job of tracking an index’s performance than first- and second-generation ETFs and provide a competitive offering for investors seeking access to remote-reach markets, less liquid benchmarks or difficult-to-execute strategies that would be costly for traditional ETFs to operate.

Critics of synthetic funds point to several potential dangers, including counterparty risk, collateral risk, liquidity risk and conflicts of interest. A 2018 report on exchange-traded funds by the European Central Bank found that “while counterparties are typically connected with many ETFs, most ETFs rely on a single counterparty.” In many cases, counterparties are connected to ETF issuers through ownership links to the same parent bank. In addition, investors may not be aware of the complexity of the relationships between ETFs and their counterparties.

Fourth-Generation ETFs: The first three generations of ETFs are passively managed, tracking both large indices and those that are less well known. In March 2008, Bear Stearns launched the first actively managed ETF — a current yield fund called Triple-Y that aimed to generate higher returns than a money market fund by investing in a diversified basket of fixed income securities. The fund was rebranded under the J.P. Morgan moniker after the bank acquired struggling Bear Stearns that same month, on the eve of the 2008–’09 financial crisis.

 Today there are nearly 400 actively managed ETFs in the North America representing approximately $125 billion in assets. PIMCO’s Enhanced Short Maturity Active Exchange-Traded Fund (MINT), with nearly $14 billion in assets, is the largest actively managed ETF, mainly holding corporate debt with less than one year in remaining maturity. Similarly, the $13 billion JPMorgan Ultra-Short Income ETF (JPST) seeks to maintain a duration of one year or less by investing in investment grade, U.S. dollar–denominated fixed, variable and floating-rate debt. Such active bond ETFs appeal to investors seeking relative safety but higher yields than those offered by money market instruments or long-term Treasury securities. Until recently, actively managed ETFs were largely restricted to such niche segments.

Most actively managed ETFs are as transparent as traditional ETFs: They publish online a full list of their holdings on a daily basis. That transparency, however, can reveal a manager’s strategy and create the risk of arbitrage by other investors trying to front-run its positions. To combat that, some ETF providers have gotten the SEC to loosen the regulations and approve several actively managed, nontransparent exchange-traded funds (ANTs). These new actively managed ETFs disclose their holdings monthly or quarterly, or share a proxy for their holdings; they are not required to disclose them on a daily basis. In the spring of 2020, American Century launched the first actively managed nontransparent ETFs: The American Century Focused Dynamic Growth ETF (FDG) and the American Century Focused Large Cap Value ETF (FLV).

The appeal of actively managed ETFs is that they trade like a stock but are structured like a mutual fund. While passively managed ETFs are designed to replicate an index, actively managed ETFs aim to outperform a benchmark return. To put it differently, passively managed ETFs offer the same exposure as the market, known as beta, while actively managed ETFs focus on generating higher returns than a benchmark, known as alpha. Not surprisingly, actively managed ETFs typically have higher costs than their passive counterparts.