The ETF Industry Turns 20

While exchange-traded funds still seem like the new kid on the block, it's been 20 years since the inception of the first United States ETF,  SPDR S&P 500 (SPY). At the time, few imagined this fund would change the way people invest. Today, a slew of ETFs are used by individuals, advisors, and institutions for purposes as varied as long-term, buy-and-hold investing to very short-term speculation in exotic asset classes. There are now over 1,440 U.S. ETFs, and their assets account for about 13% of mutual fund and ETF assets. But through it all, SPY remains the most popular and heavily traded ETF.

Never Let a Good Crisis Go to Waste
According to The ETF Book by Richard Ferri, the inspiration for the first ETF was partly born from the wreckage of Black Monday. On Monday Oct. 19, 1987, the Dow Jones Industrial Average fell over 22%. Program trading, in which institutional investors trade large blocks of stocks and futures simultaneously, received some of the blame for the crash. In response, regulators and exchanges established rules that would trigger certain trading restrictions during market downdrafts. These rules were designed to prevent future panics and promote market stability. However, these trading curbs had the effect of limiting the use of futures and program trading just when institutions needed liquidity. This created demand for a liquid product to serve as an alternative to index futures and which would allow investors to implement basket transactions via a single instrument on the stock exchange.

In January of 1993, the American Stock Exchange collaborated with State Street Global Advisors to launch SPDR Trust, Series 1, better known as SPDR S&P 500. While there had been other attempts to launch an ETF, SPY was the first to succeed because it had both institutional and retail appeal. Institutions benefited from the access to liquid trading of a basket of securities. The shares sold for approximately one tenth the value of the S&P 500, giving retail investors access to a low-cost index fund with an investment minimum of a single share. In its first year, SPY gathered $500 million in assets and today has assets over $120 billion.

Structural Issues
SPY, unlike most modern ETFs, is organized as a unit investment trust under the Investment Company Act of 1940. Compared with other ETF structures, the UIT structure has several drawbacks. For instance, UITs are nonmanaged entities and thus do not have a board of trustees. They have to follow rigid rules in replicating their benchmark index--They must employ full physical replication. ETFs structured as UITs are not allowed to use sampling techniques. Furthermore, they cannot hold any securities that are not included in their benchmark index (such as index futures). UITs are also prohibited from reinvesting dividends paid by their portfolio companies. Instead, they hold cash in a non-interest-bearing escrow account until it is paid to shareholders. SPY's dividend payable date is more than a month after its ex-dividend date, so it holds onto investor cash for a significant period. The cash drag that can result may cause the fund's performance to diverge from that of its benchmark index, particularly during volatile market conditions or in high-interest-rate environments. Finally, as a UIT, SPY cannot engage in securities lending, a practice many index funds use to help offset the negative effects of expenses on tracking performance.

It's a Marathon, Not a Sprint
Over the past 20 years, SPY underperformed its benchmark index by only 0.13% per year on an annualized basis. This is a truly remarkable feat, particularly in light of the fact that its average expense ratio over the period was also 0.13%.

The fund has also stacked up well against its actively managed peers. Over the past two decades, just 108 distinct, actively managed large-blend mutual funds have survived the period, while 158 have either closed or been merged away. Fund companies don't usually close top-performing funds, so it's likely that performance gap between SPY and the average actively managed large-blend equity fund was even wider than the 20 basis points shown in the table below.

I Spy Competition
In 1996, the precursor to iShares launched a series of ETFs structured as regulated investment companies rather than UITs. The RIC structure allowed for more flexibility. ETFs structured as RICs could use sampling techniques to build their portfolios, reinvest dividends, and engage in securities lending. In 2000, iShares launched its own S&P 500 tracking fund,  iShares Core S&P 500 ETF (IVV).

In 2001, Vanguard entered the fray with its own unique spin on the ETF structure. Rather than issue ETFs as stand-alone funds, Vanguard uses a patented share class structure whereby its ETFs are a separate share class of its open-end mutual funds. Vanguard launched an ETF share class of its S&P 500 index fund in 2010.

Structural differences in can lead to differences in performance. In 2012,  Vanguard S&P 500 ETF (VOO) returned 15.98%, just 0.02% shy of the benchmark, while SPY lagged by 0.16%. Vanguard's good performance was in part attributable to share-lending revenue and its ability to reinvest dividends.

Is SPY Still Relevant?
It might seem silly to question the relevance of a $120 billion fund. But given the structural details outlined above, and the resulting differences between funds, it's an important question to ponder--especially for long-term investors. For long-term investors, IVV or VOO will likely offer better performance than SPY. However, as the most heavily traded security on the New York Stock Exchange, SPY offers plenty of liquidity. It trades roughly $20 billion a day on average. As such, it has the lowest Morningstar Market Impact score amongst all of the ETFs for which we calculate this measure. Morningstar Market Impact is a measure of the cost of liquidity in ETF shares that is based on two factors: how tightly an ETF's price tracks its net asset value and the share of average daily volume traded by an investor. If an ETF's price moves erratically relative to its NAV, a large trade is likely to result in unfavorable price impact for the investor. While the drawbacks of the UIT structure can result in inferior performance relative to its RIC competitors, SPY has a tremendous liquidity advantage. Due in large part to this advantage, SPY remains the preferred choice for investors looking to execute large trades and frequent traders.

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