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ETFs rose from the ashes of Black Monday. Now they must innovate.

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Traditionally, 30th anniversaries are celebrated by the gift of pearls; however it is doubtful that anyone who is marking the 30th anniversary of “Black Monday” is exchanging presents. However, as with all disasters, there was something wonderful that came into being because of this crash — Exchange Traded Funds (ETFs).

Very few people realize that one of the driving forces in investing and markets today arose from the ashes of the crash of 1987. The U.S. government, through the Brady Commission, cited mutual funds meeting redemption orders and institutional investors utilizing portfolio insurance or program trading as the causes of the crash.

{mosads}Robert Shiller believed that investor panic drove the market. Whichever version you believe — or, if you believe it was a combination of the two — it was clear that computerized trading of baskets of securities was a major force in the massive stock market drop.


Nathan Most, an executive of the American Stock Exchange, and his team (including Steven Bloom) began studying the crash of 1987 with the goal of finding a different way to trade baskets of securities.

Through much trial and error and after a long, arduous road at the Securities and Exchange Commission (SEC), they finally launched the first ETF in the U.S. — the SPDR S&P 500 Trust ETF (The Spiders) on Jan. 22, 1993.

Little did all of us know that we were witnessing the birth of an industry that would come to dominate the markets. The path forward is clear: Diamonds, QQQs, BGI’s portfolio of ETFs and the thousands of other products that followed.

30 years later, this robust industry is facing tremendous challenges of its own. The growth of passive investing at the expense of active investing cannot be denied; it is as relentless as the incoming tide.

However, active investing will not disappear by any means. Rather, the balance between active and passive strategies will reach a more sustainable point (with movement back and forth as markets dictate) after the current explosive growth of passive runs its course. 

I believe that there are three major interconnected challenges underlying the continued innovation within the ETF space. First is concentration of distribution. A few large firms and their distribution channels continue to drive the ETF field.

It is increasingly challenging for the small-to-medium-sized player (or even the lower end of the large player) to compete for shelf space to showcase their products to financial advisors and their customers.

The second major concern is the lack of seed capital for new issues. The vast majority of new products were launched with inadequate seed capital to sustain them through the very challenging market adoption phase.  

Directly related to these points is ETF liquidity, including the liquidity of the underlying constituents. Just as we see a concentration in assets under management in the main equity products of the top sponsors, the liquidity or trading in the world of ETFs is also highly concentrated.

This makes it increasingly difficult for the new, small product from the small-to-medium-sized firm to establish a foothold in the space. Lack of seed capital combined with the inability to access distribution channels creates a scenario that, despite the headlines, puts the entire business at risk of losing its innovation, the core foundation of the ETF industry.

The markets are faster and less expensive to use than ever before. The exchanges have built tremendous scalable technology platforms that, combined with other trading venues, have created, robust and rigorous markets capable of handling tens of millions of transactions.

Technology is not the problem for the new, small ETF — it’s market structure. The current market structure fragments liquidity across dozens of markets, liquidity pools and trading systems. This may work wonderfully for ETFs like Spiders and the QQQ (based on the Nasdaq 100 index), and large companies such as Apple and Exxon, but this fragmentation works against the small ETF and the small public company as well.

We need to take a step back and look at how we can concentrate liquidity and trading volume with a single market participant on a single venue to accommodate those ETF issuers and small public companies that want that choice.

Market participants need to have economic incentive to trade securities, as trading drives liquidity, and liquidity drives capital.

Allowing a monopoly on trading of a security on a single exchange with a single-market participant, a risk-derived spread, suspended unlisted trading privileges (UTPs) and dark pools may appear to fly in the face of Reg NMS and the recent market structure trend, but I do not believe there is a single-market structure that works for all tradable products.

This concentration of trading will create the economic incentive in the system to compensate market participants to re-commit to providing seed capital and follow-on capital for substantial periods of time, thus allowing the new, small innovative ETF product (or small public company) the means to weather the early adoption phase by investors and traders.

This initiative is only temporary until ETFs and small issuers gain critical mass and must be selected by the sponsor or issuer.

A change in market structure will not, in and of itself, change distribution. But, if innovative products that fill a need of investors and traders have better chance of reaching critical mass, they will find their way into the hands of customers.

ETF innovation is too important to investors — both retail and institutional — to avoid taking a fresh look at market structure. Markets are cyclical in nature. Innovation always follows disruption — whether it be a major crash or a technology glitch.

All actions have repercussions and unintended outcomes. Cutting edge products deserve cutting edge markets. 

John L. Jacobs is the distinguished policy fellow and executive director of the Center for Financial Markets and Policy at Georgetown University’s McDonough School of Business and is a principal of the ETF BILD Project.


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