From 0 to 100 – a summary of the short but exciting history of ETFs

The idea to make broadly diversified and cost-effective passive investments was already common in the last century. The current acceptance of this asset class has been a long time coming. 

Louis Bachelier and Harry Markowitz are considered the originators of the ETF idea. Bachelier, a mathematician, was already conducting research on the stock market around 1900 and is now regarded as the founder of financial mathematics. However, during his lifetime he was not noticed by the public – partly because it was, as a mathematician, then considered dubious to engage in stock analysis. 

Markowitz’s modern portfolio theory (MPT) gave new impetus

It was only in the 1950s that Harry Markowitz, then a young student, became aware of Bachelier's findings. He further developed Bachelier’s approach and introduced MPT in 1952. Markowitz received the Nobel Prize in Economics in 1990 for his work, which is still used to this day in calculations involving long-term investments.

The core idea behind MPT is as follows: ff you spread your investments across different assets, the risk decreases, while the probability of returns remain the same. It is crucial that the individual assets correlate as little as possible with each other – i.e. that they are as independent as possible. This principle of diversification has become a guide for generations of investment advisors. However, the theory has also been questioned: the financial crises from 2000 onwards showed that even widely diversified portfolios are not immune to losses: equities, bonds, real estate and commodities then came under pressure at the same time. 

The financial world has changed considerably since Markowitz’s time, when there was no electronic trading. Today, markets are globally networked and fragmented. Equities remain similar, but there are many more types of derivatives. Stock exchange transactions can now be carried out from home within seconds. And price fluctuations are many times higher than in the 1950s. 

Nevertheless, one thing is clear: diversification is important, and a broadly-based portfolio generally offers more security than individual investments. However, diversification is not a guarantee against losses.

Costs as an important success factor

In addition to a growing awareness of risk diversification, the burgeoning realisation that professional fund management does not always deliver what it promises has also given a boost to index funds. In 1967, in an experiment conducted by the respected US financial magazine Forbes, editors threw darts at the Wall Street Journal's stock price list in order to form a portfolio. 17 years later, the average return of the Dart Fund was over 9 percent annually, well above that of the S&P500 – something that many professionally managed investment funds had failed to achieve. 

It was in this environment that William Sharpe and Bill Fouse developed the world's first index fund in 1971, the "Samsonite Pension Fund", named after the suitcase heir who had studied with Markowitz. This first index fund contained 1,500 shares listed on the NYSE and its price was determined once a day. Sharpe is the inventor of the ratio 'Sharpe-Ratio' and was awarded the Nobel Prize, together with Markowitz and Merton Miller, in 1990.

The first ETFs came onto the market in the USA in the 1970s. And the investment company State Street Global Advisors constructed the first index fund in 1970. 

Convinced of the idea, John Bogle and Burton Malkiel founded their own investment company, Vanguard, with exclusively index funds on offer. The aim was to offer these index funds to the general public at the lowest possible cost. Vanguard's first index fund, the Vanguard 500, was a great success and increasingly convinced pension funds of the merits of passive managed investments. Today, Vanguard is the second largest provider worldwide after Blackrock, with more than 5 trillion US dollars in assets under management. It continues to be organized as a cooperative. One of John "Jack" Bogle’s most famous sentences is "Don't look for the needle, buy the haystack". Warren Buffett said of Bogle, who died in 2019, that he had done more for private investors than anyone else. 

"Don't look for the needle, buy the haystack!"

Vanguard didn't enter the German market until 2017. As of April 2020, 36 ETFs are traded by Vanguard on Xetra and the Frankfurt Stock Exchange.

In the 1980s, the range of index funds in the USA grew steadily. At that time, they were not called ETFs, but Cash Index Participations (CIPs) and Index Participation Shares (IPS). They were listed on the American Exchange (AMEX) and the Philadelphia Stock Exchange. In Germany, too, the first index fund, the CB German Index Fund, was offered at this time by a Commerzbank subsidiary, but only to institutional investors.

The first ETFs were listed on an exchange in Canada in 1990. The first ETF in New York was the Standard & Poor's Depositary Receipt, also known as the spider due to its stock exchange symbol SPDR. The Spider ETF, which is a copy of the S&P 500, is now the largest ETF in history. In February 2020, the assets under management amounted to almost 280 billion US dollars. Due to insufficient turnover, the predecessor products, CIP and IPS, were renamed and transferred to New York. 

ETFs were first offered in Europe in 2000. Deutsche Börse pioneered two ETFs on the two European blue-chip indices EURO STOXX 50 and STOXX Europe 50.

Also successful with private investors

Today, 20 years later, there are almost 7,000 ETFs worldwide. 1,500 index trackers are offered on Xetra and, in Frankfurt, the trading volume in February 2020 was about 20 billion euros. 

And while, in the early decades, ETFs were primarily an instrument for professional investors, in recent years more and more private investors have discovered the products for themselves – especially in the current low-interest environment. Their share of the ETF trading volume is around 8 percent, and around 35 percent in terms of the number of transactions. Given the advantages, this is no wonder: low costs, easy to understand, simple to implement. The politician Friedrich Merz recently described it as an instrument for the radical democratisation of investment, as they give private investors access to tools that were previously reserved for professionals. 

Way to go! 

Author: Edda Vogt, März 2020, © Deutsche Börse