SPY At 25: Institutional Rock Star

December 06, 2017

The SPDR S&P 500 ETF (SPY), which turns 25 on Jan. 22, 2018, is The Clash of investing: counterculture and revolutionary for its time, now a favorite of those in business suits and corner offices the world over.

This first U.S.-listed—and still the largest at the global level—ETF was almost unlike anything that came before it. Eventually it would come to upend decades of accepted financial wisdom, bending the investment paradigm around it. Thanks to SPY, and the ETF revolution it kick-started, investors stopped thinking of the markets in terms of inefficiencies to exploit, and began dividing it into risks and exposures, with allocations to each. Money management was never the same again.

"SPY transformed the way investors thought about investing," said Jim Ross, executive vice president of State Street Global Advisors and chairman of the Global SPDR Business. "I can't say that was even a twinkle in our eye 25 years ago."

Although SPY was never intended to be more than a trading tool for institutions, it quickly became a must-have fund for all market participants, from hedge funds to mom-and-pops. And though SPY has ceded market share in recent years to its lower-cost competitors, its unrivaled liquidity and name recognition prove there's plenty of life left in this Casbah to rock.

Fixing A Stock Market Crash

With over $250 billion in assets, SPY is by far the largest U.S. ETF; it's nearly double the size of the next-largest fund, the iShares S&P 500 ETF (IVV). But when SPY first launched, nobody—not even its originators—expected it to become the juggernaut it is today.

"The folks working on SPY thought there might be three or four ETFs in the U.S.," in total, says Ross.

SPY was the brainchild of Nate Most and Steven Bloom, the two-person product development team at the American Stock Exchange who, in the 1980s, were tasked with reverse-engineering a product that could have withstood the 1987 Black Monday stock market crash.

They devised a concept based on "warehouse receipts"—documents that show proof of ownership over a quantity of stored commodities. To shift ownership, commodity traders would exchange these receipts instead of moving product from warehouse to warehouse.

Most and Bloom wondered if something similar might work for equity markets: Stocks could be "warehoused" in a unit investment trust (UIT), shares of which investors could trade as much as they liked, without impacting the underlying stocks or incurring trading costs for fellow investors.

"It would offer all the instant access of futures, but backed by something physical," said Eric Balchunas, senior ETF analyst for Bloomberg Intelligence.

Though individual elements of the concept weren't new, the idea of an index-based UIT trading intraday on an exchange was. Most and Bloom's idea took over five years to get off the ground, and several banks and fund companies passed on it, including Wells Fargo Nikko, which eventually became Barclays Global Investors and then iShares.

Then, in 1990, AMEX approached State Street, which agreed to serve as trustee to the new UIT. Its backing of the product gave SPY the credibility it needed to be taken seriously by large institutions, the primary intended user.

SPY Launches, And Stumbles

On Jan. 22, 1993, SPY received its initial seeding: $6.53 million—a paltry sum today—and began trading a week later. It debuted with a splash: On its first day, SPY traded just over 1 million shares.

The fund grew quickly. By the end of the summer, the fund had $270 million in assets, with daily volume of at least 100,000 shares. Volume, and assets, climbed higher every day.

It wasn't all smooth sailing for SPY, however. In 1994, a year after SPY launched, the ETF saw net outflows instead of inflows, a troubling sign for a brand-new investment product. But those flows quickly reversed in 1995, and SPY hit its first $1 billion in assets that year. It then doubled in size almost every year until the dot-com crash. The "SPDR," or “spider” as it was called, had found its legs.

 

Source: Bloomberg; data as of Dec. 4, 2017

 

SPY's Secret Sauce

SPY's secret sauce, and ultimately the secret sauce of all ETFs, was its creation/redemption mechanism, which involves the in-kind exchange of a fund's underlying securities for shares of the ETF, and vice versa.

Special market makers known as "authorized participants" could make money by arbitraging the differences in dollar value that arose between SPY's shares and its underlying securities. Doing so also benefited the ETF by pushing its net asset value closer to the value of its underlying stocks, thus ensuring SPY would trade near fair value throughout the day.

Creation/redemption was initially incorporated to keep costs in SPY low. But it also shifted SPY's trading costs in a way that made it more transparent and investor-friendly than either futures or mutual funds. That made it especially appealing to institutions, which began to use SPY instead of futures as an overnight hedging vehicle; or in place of mutual funds to gain inexpensive large-cap diversification.

Fortuitously, creation/redemption also ended up being more tax efficient than mutual funds, as redemptions could occur using in-kind exchanges of securities instead of selling off stock for cash and generating capital gains. Unlike with a mutual fund, unwinding a SPY position didn't mean a tax hit to investors left in the fund.

"With mutual funds, it was disruptive to remaining shareholders if a market timer was constantly moving in and out of your fund," said Kevin Quigg, former Global Head of SPDR ETF Sales Strategy Group and current chief strategist for ACSI Funds. "Not only could you do that with SPY and it wouldn't be frowned upon, it was beneficial to the other shareholders, because it created liquidity."

RIAs, Online Brokerages Boost Adoption

As SPY grew larger, so did its appeal to the investment community outside of institutional traders. In large part, that was driven by the online brokerage, which came of age in the dot-com boom and made security trading open to everybody, not just broker-dealers or large institutions.

Online brokerages peeled back the curtain before stock-picking and "deconstructed active management," says Quigg, thus encouraging SPY's adoption by retail investors and the growing fee-only RIA community.

"Suddenly, technology made it very easy for you to buy a stock, or an ETF," he added. "With SPY, you could take more control over your book of business."

World's Most Liquid Security

Today SPY is the most liquid and well-traded security in the world, with less-than-a-penny spreads and an average daily volume of 53 million shares. Nothing else even comes close: AAPL, the world's most-traded stock, has an average daily volume of 28.6 million shares.

SPY still has a devoted institutional following: According to 13-F filings, 70% of SPY's ownership is by institutions, such as J.P. Morgan Chase (13%), Bank of America (7.7%) and Goldman Sachs (4.6%).

"For any institutional investor, SPY's pretty much the go-to," said Bloomberg’s Balchunas.

That's in no small part a quirk of its structure. As a UIT, SPY must replicate its index exactly, and can't reinvest any dividends—meaning it provides purer exposure to its index than competing ETFs, at a cheaper price than futures.

"SPY trades very consistently with how you'd see futures trade," said SSGA’s Ross. "Institutions that trade a lot appreciate that."

Yet SPY has as many uses as it does users: transition management, risk management, and of course, good ole-fashioned large-cap exposure. SPY also has the deepest and most liquid options market in the world. "SPY is like a Swiss army knife," noted Balchunas. "It means a lot of things to a lot of different people."

SPY In Fee Wars

SPY has an expense ratio of 9 basis points, making it more than twice as expensive as IVV and the Vanguard S&P 500 ETF (VOO), at 4 basis points each. As such, the two have steadily eroded market share from SPY, which saw net outflows of $6.7 billion as of Dec. 4, 2017, while overall ETF inflows have shattered old records. Whereas SPY once represented more than 60% of all assets in the ETF marketplace, today the fund only accounts for 7.5%.

SPY, which debuted with an expense ratio of 0.20%, has also had its share of price-drops over the years; in fact, the ETF structure was designed to be a low-cost alternative to other trading instruments, like futures.

Yet State Street isn't worried about SPY's future, because for its main users—institutions—SPY's total cost of ownership is often substantially lower than the competition.

"Depending on what your holding period is, the cost of buying and selling can overwhelm the benefit of expense ratio," said Ross. "[Institutions] are more concerned about liquidity, spread and consistency of markets than what is a very small basis-point difference" in expense ratios.

 

1ST CREATION ALMOST DIDN’T HAPPEN

Not many people know the world’s first S&P 500 ETF was almost an S&P 499 ETF.

“The night before filing, somewhere between all the cutting and pasting, we had lost a security,” said Jim Ross, executive vice president of State Street Global Advisors and chairman of the Global SPDR Business.

Though it’s hard to imagine today, with thousands of ETF creations and redemption orders occurring simultaneously throughout the trading day, someone, at some point, had to build the first creation unit. Someone had to make sure the plumbing SPY ran on actually worked.

And it almost didn’t.

“It was a brand-new process. We were figuring this out on the fly,” said Ross.

Ross, then a fresh-faced State Street employee, had joined the company’s SPY team just months before launch. He helped usher SPY through its final, first-of-its-kind preparations: Whereas other unit investment trusts created new shares in cash, SPY was designed to create in-kind, with securities, which required extra steps.

At 4 p.m. the day before filing, State Street had to take a creation unit’s worth of the securities in the S&P 500 Index, price it, then have the financial statements audited by PricewaterhouseCoopers overnight, so they’d be ready to file with the SEC at 9:30 the next morning.

At some point in all those steps and printouts, they lost a security.

“Literally the auditor is trying to add up the portfolio, and it’s not adding up, because there were only 499 securities,” said Ross.

To find the missing security—”I don’t even remember which one it was anymore,” said Ross—meant frantically combing through the pricing document, page by page, security by security, at 11:30 p.m.

They eventually found the missing stock, and the initial seed audit and registration went off without a hitch. But Ross never forgot how it almost all fell apart before it began.

“Today it all happens instantaneously, electronically and very straightforward,” he said. “But then, although we had tested it a lot, honestly, we were still just hoping it would work.”

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