Nate Most, who conceived of the first exchange-traded funds (ETFs), died December 3rd at home in the San Francisco Bay area. Most was incredibly busy up to the last year, with frequent trips to cities from New York to Hong Kong and Shanghai. Always on the cutting edge and playing an integral part in the continuing development of ETFs, Most's idea of "retirement" at age 90 would have put most business travel schedules to shame.
Most leaves behind his family and a host of dear friends in the index industry, the present author included. There is what feels like a large empty space where Nate used to be. He was active and lively, and bubbling with passion and great ideas up to his last days. Even up to a couple weeks ago, he had written me extended comments including his thoughts about the new Gold ETF and his excitement about the direction the industry was heading.
Most was a longtime employee of the American Stock Exchange, where his background and a unique combination of circumstances helped to generate the very first ETF, the beginnings of an industry that has become the most rapidly growing sector of the financial services industry, and now includes over $260 billion in assets globally. And amazingly, all of this happened on Most's watch in the last 15 years of his life after he turned 75.
Nate's story - which is inextricably linked to the history of ETFs - is a remarkable one. The origin bears a direct relation to Nates background and vision and to the financial distress faced by the American Stock Exchange in the 1980s. Faced with a chronic lack of resources at the AMEX, Most took things in his own hands and came up with a product that he thought could make the AMEX some money. How he came up with the mechanism had as much to do with his background as a commodities trader and his observations about the mutual funds market as it had with anything that he'd previously done at the AMEX.
A physicist by training, Most worked on submarine acoustics for the United States Navy during World War II (cruising in dangerous proximity to Japanese submarines). He spent years traveling throughout India and the far east to sell acoustical material to theaters, Most importantly for exchange-traders, however, Most got into the cooking oil business in the 1960s. At that time, Most starte working for the Pacific Commodities Exchange.
There, he became accustomed to warehouse receipts, "You store a commodity and you get a warehouse receipt and you can finance on that warehouse receipt. You can sell it, do a lot of things with it. Because you don't want to be moving the merchandise back and forth all the time, so you keep it in place and you simply transfer the warehouse receipt."
It is here that the mental spark that ultimately led to the first ETF was spawned.
Initially, Most worked with the AMEX on index products like the Major Market Index, which was designed to mirror the Dow Jones Industrial Average, because Dow refused to allow derivatives to be based on its index. However, Most and his derivatives department had a problem. They had no money. The American Stock Exchange was having severe difficulties drawing enough business to be profitable.
"They had a basic volume of about 20 million shares a day and it just stayed there, no matter what they did. They were spending all kinds of money to get new listings, but were unsuccessful. From our side, we needed a lot of money for the things we wanted to do and we couldn't get it. They kept telling us we weren't making enough profit. So I thought[em]well, maybe I could help the equity side and bring in some money. Well, here I see mutual funds just booming, gaining market fast, without being able to be traded. So I thought[em]well, why not? I didn't realize at the time all the complications that would be involved."
As it turned out, there were some two years of complications involved. Although the approval process was underway in 1990, the first exchange-traded fund (Standard & Poor's-500 Depositary Receipts, or SPDRs) did not hit the market until January 1993. Plagued by seemingly insurmountable regulatory hurdles from SEC, as well as daunting logistical hurdles involved in not knowing exactly how the new investment vehicles would perform or how exactly investors would use them. It was a major accomplishment for AMEX and State Street Global Advisors (SSgA) to bring the ETFs to the market.
The first ETFs were set up as unit investment trusts (UITs) because of the ease and flexibility of running the fund under such an arrangement. UITs were less expensive to run because they didn't require a board of directors. As more funds were released and other benefits (like lack of dividend drag and ability to loan stocks) of open-ended funds were factored in, this cost seemed less important.
The introduction of the SPDRs in 1993 was soon followed by the S&P MidCap Fund, managed by the Bank of New York (BNY). Open-ended WEBS were introduced in 1996. They were revolutionary new funds that allowed American investors to buy into foreign stock indexes by purchasing shares on the American Stock Exchange. Most left the AMEX to work on the WEBS, eventually moving to Barclays Global Investors when BGI purchased the WEBS. At BGI, Most assumed the title of Chairman of the Board, the iShares Trust.
BGI, of course then went on to grow into the world's largest manager of ETFs.
Excerpt from Exchange-Traded Funds - A Insider's Guide to buying the Market - by Will McClatchy and Jim Wiandt The forward to the book written by Nate Most:
On December 31, 2000, there were 65.6 billion dollars invested in what we now call exchange-traded funds, or ETFs. On April 30, 2001, even after a falling market, the amount of funds under management for ETFs had reached 73.3 billion dollars. On the American Stock Exchange, trading in ETFs now dwarfs that of all other equity, even though there is now also trading on other U.S.exchanges and trading systems. The New York Stock Exchange has one ETF currently trading and is planning to introduce more.
A number of stock exchanges around the world, including the exchanges in Hong Kong, Singapore, London, Frankfurt, Sydney, and Torontoare already trading ETFs. Many others are planning to introduce them soon, including the Tokyoand Osaka Stock Exchanges in Japanand stock exchanges in other European countries. When I reflect on what started as a simple goal and how it all evolved into ETFs, and the number of critical requirements that had to be met and overcome to make the ETF possible, I can only wonder how we were able to accomplish it.
At the time of the writing of this foreword I had already spent a total of over 35 years in commodity trading and commodity and stock exchange management, where much of my work involved the design of new financial instruments. Prior to that, I had embarked on a career as a physicist and engineer specializing in acoustics. After World War II, my work devolved mainly into international trade and management, including trading and managing international commodities. The development of the ETF design would have been difficult without this experience and background. Further, I know of no other financial instrument for which its genesis evolved principally from a stock exchange's need to find something to trade. Generally, it is the other way around.
The American Stock Exchange, commonly known as the AMEX, originated at the curb on Broad Streetin New York. Traders stood at their selected lampposts on the street curb and brokers leaned out of the upstairs windows and yelled or hand signaled orders to the traders below. When I joined the AMEX staff in December 1976, it was still referred to as the Curb Exchange. Originally, it served as the market for smaller stocks that didn't qualify for listing on the New York Stock Exchange. When the Nasdaq dealer market opened to non-dealer investors, many of the smaller new company stocks began to trade there instead of on the AMEX. The AMEX soon began to experience difficulties in obtaining new listings.
Responding to this, the AMEX began all types of new programs to attract listings. Most of these programs, unfortunately, were not as successful as AMEX management had hoped. The trading volume remained at approximately 20 million shares per day, a very small number compared with the growing trading volume on the NYSE and Nasdaq.
My position at the Exchange was head of new product development on the derivatives side of the Exchange's business, where we were doing relatively well. In my work, I have always thought in terms of looking 'outside the box' in new product design. Accordingly, in viewing the Exchange's efforts to increase its trading volume, I thought that it ought to be looking for trading in different classes of securities not already trading on an Exchange, rather than continuing to fight what was obviously a losing battle.
The most obvious securities of this type were mutual funds, then increasing rapidly in popularity. I was encouraged by Professor Burt Malkiel of Princeton University, who was then chairman of the Exchange's New Product Committee and a member of the Exchange's Board of Directors. Professor Malkiel had written the book A Random Walk Down Wall Street which made the case for investing in broad market indexes.
My first approach was to determine whether mutual funds in their present form could be traded. A visit with Jack Bogle, then head of the Vanguard Group, discouraged this. Jack made the point that mutual funds could not deal with rapid movements in and out of his funds without substantially increasing operating costs. Jack was the innovator of low-cost mutual fund operations.
To solve this problem, I returned to my commodity experiences and thought that we might separate the functions of fund management and exchange trading by using what would essentially be a warehouse-type operation. Portfolios of stocks conforming to an established index would be deposited with a trust bank, which would then issue a depositary receipt to the depositor. The receipt would be divisible into a large number of pieces[em]50,000 has become typical. The divided pieces could then trade on the Exchange as equity securities. These pieces would not be redeemable by the fund, but could be reassembled into the full depositary receipt and submitted to the trust bank in exchange for the underlying share portfolio.
This was the key concept of the ETF from which all of the other features evolved. As the design developed another feature appeared[em]the potential for arbitrage. This was seen as the mechanism that would cause the pieces or shares to track the value of the underlying portfolio during the trading day. Since new ETFs could be created at any time during the trading day by purchasing the portfolio of stocks to be delivered to the fund at its NAV at the close of trading, if the share price rose above the value of the underlying portfolio, those shares could be purchased and deposited with the trust bank in return for a new divisible warehouse receipt. New pieces from the receipt could be sold to take advantage of the price gap and earn an arbitrage profit. If the shares traded below their intrinsic value, the reverse transaction could be executed. The arbitrage transactions would quickly close any price gap.
Many other features developed as the design of ETFs evolved. The SEC's approval of selling traded shares on a downtick permitted the ETF shares to serve as a substitute for a future contract in hedging operations. Few, other than very large investors, can deal with the daily variation margin in futures trading, and this downtick approval feature provided both large and small investors with the ability to hedge their positions by short sales of ETFs. The importance of this feature was demonstrated by short sale hedging on the Nasdaq 100 during the exchange's recent precipitous price drop. The assets under management of this ETF doubled during the drop through the creation more shares needed to lend to short positions to make delivery. Another feature is that purchase and redemption from the underlying fund in shares, not cash, results in investors going in and out of the fund without creating a tax event for the fund. This helps minimize year-end capital gains distributions by the fund. Still another feature is the distribution of created shares to investors in book entry form only at the Depository Trust Company. This eliminated the need for the fund to keep track of individual shareholders, a very substantial reduction in the cost of operating these ETFs.
The sum of these and additional features of ETFs have made them attractive to investors and have resulted in their rapid penetration of the investment market. Listing these features doesn't mean that they were easy to achieve. The first response of the AMEX attorneys to the concept of ETFs was that the SEC would never approve such securities. When we finally obtained the Legal Division's approval to proceed, they proposed using a unit investment trust structure because it required neither a board of directors nor corporate management, among other reasons. The outlook was difficult.
What changed the climate for the security at the SEC was, interestingly, the crash of '87. The failure of the 'portfolio insurance' concept simply to sell stock index futures short when the market started down was a major factor. In the '87 crash, the drop was so precipitous that there were no futures buyers to sell to. I believe that this caused SEC management to begin thinking of hedging instruments under SEC jurisdiction, which could better serve for hedging. To me, this was a very important factor in getting SEC approval of the many exceptions to the 1940 Act, which the ETFs required. Even with this, it took three years and the expertise of attorney Kathleen Moriarty to finally obtain that approval.
Beyond obtaining regulatory approval, another major matter to deal with was the National Securities Clearing Corporation's system for clearing trades between the stock exchanges. The ETF design required that the underlying stocks purchased to create the ETFs had to be transferred to the fund depository without cash payment, since the issued ETFs were the payment. The NSCC system consisted only of transferring purchased shares in one direction, and cash payment in the other. Fortunately, Mr. David Kelly, then president and CEO of NSCC, thought well enough of the prospect for the proposed ETFs that he persuaded his board to authorize him to modify the NSCC system to accommodate the required transfers. This was not a trivial task and would have seriously hindered the utility of the security design had it not been done.
We had chosen the S&P-500 index as the base for our initial ETF because it was and is the most widely followed index by institutional investors. We negotiated the license with James Branscome, then in charge of Standard & Poor's Index Division. Jim, too, believed that the design would be successful.
Upon receiving SEC approval, we promptly launched our Standard & Poor's Depositary Receipt, or SPDR, on the AMEX and were almost immediately branded as the 'spider people.' As could be expected, acceptance of ETFs was slow in developing and it was two years before the rapid increase in trading volume and assets under management began.
A recent major development in ETFs has been the expansion of Barclays Global Investor's involvement. BGI's first active role was as fund manager for the Morgan Stanley Capital International ETFs, initially called World Equity Benchmark Shares, or WEBS. These ETFs are based on MSCI international country indexes and are closely followed by U.S. institutional investors. These were the first ETFs to use an investment company structure rather than the UIT used for the SPDR.
Ms. Patricia Dunn, CEO of Barclays Global Investors, the world's largest manager of institutional investment funds, saw the potential for ETFs to become a major rival to traditional mutual funds. She proceeded to set up a major program for introducing ETFs based on almost every sector of the U.S.securities market and of many international markets. Management of this program for BGI is under the direction of Garrett Bouton and Lee Kranefuss. BGI's expansion in these securities resulted in the first major marketing program applied to ETFs. After only one year of operation, the program has achieved over 11 billion dollars of assets under management with assets continuing to increase even during the recent major market decline.
What is now clear is that the ETF design does not have to be restricted to indexes, though the SEC, it should be noted, has expressed some doubts as to the feasibility of actively-managed ETFs. As long as the basic design features of the ETF are followed, any portfolio of securities can be traded using this design. Requirements are: disclosure of the next days' creation/redemption basket closely tracking the composition of the underlying securities portfolio; purchase and redemption of the ETF securities with stocks; no trading in the underlying portfolios during the trading day, and, for low cost operations, issuance of the securities to a clearing and depository system such as that of the Depository Trust Company. Not all securities that are sometimes known as ETFs meet these requirements.
In view of this remarkable and almost unprecedented development of the ETF market, what can we expect next? It has now been almost 13 years since I first started down the road of trying to find something for the AMEX to trade. Since retiring from the AMEX in January of 1996, I have served as chairman of the board of the two iShares Fund Groups and have consulted for BGI in its ETF program. ETFs have more than achieved my original goal of providing the AMEX with securities to trade. By far the majority of trading on the AMEX and a major part of its current development efforts are on these securities.
What was not anticipated was the rapid expansion of ETF trading on stock exchanges around the world. It is clear to me that the ETF design is only beginning its trading and investment penetration. Its design has made it a multipurpose instrument for many of an investor's needs. Its basic concept meets a requirements that I have always believed essential for any instrument to succeed: it is simple in concept and in its usage understandable by non-professional investors.
Chairman of the Board, the iShares Trust