(Note: I originally wrote this for a post on seekingalpha.com, but it wasn’t submitted and it is probably better suited to this venue. The follow-ups hopefully will be posted there.)
In the beginning, there were no ETF’s…there was no indexing. Then along came the Efficient Markets Hypothesis, aka the Random Walk, and modern portfolio theory was on its way. That led to many events both good and bad due to faulty constraints and conditions, and misinterpreting the theory.
The worst case of it and most public was by a Nobel Laureate of all things who played a major role in the development of the theory, Myron Scholes. That involved the formation and collapse of Long Term Capital Management (LTCM). LTCM was headed by John Merriwether, who had been a professor and left to run the risk-arbitrage desk at Salomon Brothers. After being involved in a scandal of fixing ‘non-competitive’ bids in U.S. treasury auctions, he decided to use his options theory and start what at the time became the biggest trading company of all time. The firm had a load of PhD’s, including Merriwether, two Nobel Laureates, Robert C. Merton and Myron Scholes, who were the experts in options theory. It’s collapse in September 1998, was the biggest in history and threatened the entire financial system . In the long lead up to the collapse, Fed Chairman Alan Greenspan, the ‘maestro’ took a laissez faire approach as he did with a total of three crises on his watch. However, just after he was appointed in 1987, came the dotcom bust, which he handled brilliantly. His explanation for doing nothing in the others was that you don’t know you are in a bubble until it busts. That from the Fed Chairman. Myron Scholes was dumbfounded at what went wrong, and reportedly Merton said to him, “Myron, it’s just a theory.” That is exactly what the Efficient Markets Hypotheses is.
Among the faulty assumptions in the Random Walk Hypothesis are: 1. All information on a stock is known by all market participants, therefore the price of a stock at any time is the equilibrium price; 2. There are no short trades; why did it take so long for ‘geniuses’ to realize there are faulty assumptions?
It is the very assumptions in the Random Walk Hypothesis that gave an impetus to portfolio indexing and ultimately to ETF’s. Professor William F. Sharpe, PhD, and now emeritus at Stanford University, began consulting with Wells Fargo Investment Advisors in the 1980’s. In 1986, the management was hired away by a New York bank setting up an investment operation in San Francisco. Wells hired a colleague of mine Frederick Grauer, PhD (and only one of two Phi Beta Kappa’s I have ever run across int the investment business), at Merrill Lynch. He was promised a significant bonus if he could simply maintain the assets at their current level plus more if he could grow the assets, which he did. Grauer was the most brilliant person I have ever met in 43 years of investment experience. At Merrill, we figured he would be there for a year and then come back to mother Merrill. How wrong we were.
The first thing he did was to create what I believe was the first index fund in a bank (the prior management had done a lot with beta’s). I know this because I set up the first account for him at Merrill Lynch to use U.S. Treasury Bills as a way to ‘park ‘ funds until securities were purchased. Rather than a sales force, he made the heads of five different divisions the sales force and with his knowledge of how to present a case they were all very successful. He pioneered the use of this method as a way of adding value during the month, but always back in the market by month-end, something many indexers do today (a perfect example is what happened on last Friday’s month-end which culminated in a sharp rally in the final half hour of trading with large volume on the close).
Grauer hired an executive secretary, Patricia Dunn, who he mentored and who would eventually head up WFIA when Grauer retired. She was college educated and a quick study (not just a secretary as Carly Fiorina would say who started the same way and who Dunn would eventually replace as CEO at Hewlett-Packard).
When WFC sold the fund management group to Barclays Global, Dunn became CEO and came up with the idea of the ETF. Products similar to ETF’s had been attempted in the early 1990’s but were eventually abandoned, but Dunn came up with a way to resurrect them in the form of an ETF which she developed (I verified this with Grauer, who said the idea was all hers). Using sales techniques that had been designed by Grauer, a force of institutional salesmen was formed in 2000 to educate investment managers on the use of ETF as a tool in portfolio management. ETf’s were off and running!
As head of the fixed income department at a San Francisco investment advisor, one of my colleagues handed me a notice he had received on the new fixed income ETF’s which I was unaware of but called them. They were under the name iShares and I arranged a meeting with a representative and was sold on it right then. Later, I was invited to participate in a focus group on them and found that already some managers were using them for 100% ETF portfolios.
The attraction for small advisors was cost. Less money and resources spent on research and much lower transaction costs to develop a portfolio. Larger advisors, like mine, balked at the idea as they felt they were paid to ‘manage the assets’. While I tried to convince them otherwise, it was futile. I finally gave up and started my own company…one man, and made good use of ETF’s.
Part Two will cover how ETF’s work and what caused the rapid growth of them and eventually resulted in such broad acceptance that roboadvisors came into being many of them making use of them. Of course with every new product, abuses occur and funds are created which are not suitable for investment accounts.