Practical analysis for investment professionals
25 July 2018

The ETF at 25: Still Scratching the Surface, Says SPDR’s Jim Ross

It’s been 25 years since Jim Ross and State Street Global Advisors launched the first S&P 500 exchange-traded fund (ETF), SPY. Since then ETFs have grown increasingly popular and transformed the investment landscape.

No one is more surprised by their success than Ross himself. Still, he believes we have barely begun to realize their full potential as investment vehicles.

To mark the 25th anniversary of SPY’s launch, we spoke with Ross, who presented last month at the Inside ETFs Canada Conference in Montréal, about how ETFs have evolved in the last quarter century and where he anticipates them going in the years ahead.

Below is a lightly edited transcript of our conversation.

CFA Institute: Twenty-five years ago, you and your team at State Street Global Advisors launched the first US ETF based on the S&P 500, SPY. Did you think back in January 1993 that we’d still be talking about ETFs a quarter century and $5 trillion later?

Jim Ross: I think it’s pretty safe to say that was not exactly what we thought at the time from a vision standpoint. We thought we had a decent product. We had something that would work. Some of the features that were not considered in the early days have been added and proved to be very appealing.

The ETF’s original focus was institutional trading, not even investments. Obviously, we’ve seen a lot of different trends in the marketplace that have been part of the ETF evolution. The conversion from commission‑based products to fee‑based products has helped dramatically in that, frankly, the growth in ability for people to build long‑term portfolios for their clients has helped the ability for the ETF to grow.

It’s been a great solution for advisers and institutional investors looking to do that. I don’t think I had any twinkle in my eye that I’d be talking about ETFs 25 years later, to be candid with you, I’m happy that I am.

There sure has been much excitement throughout the ETFs journey. Do you think the future of ETFs is going to be equally exciting?

My excitement about the future of ETFs is based on the fact that in certain places we are still scratching the surface. We’re scratching the surface in fixed income and the insurance companies’ use of ETFs. We’re scratching the surface on the globalization of the ETF market into some developing markets like bigger and broader in China, bigger and broader in India.

The population’s growing. The middle‑class investors are growing dramatically. The ability for us to bring the ETFs to the marketplace is really one of the growth engines that I think is truly, truly out there.

That will take some development and work, but it’s one of the reasons I do see the continued growth of ETFs.

They’ve already helped millions of investors worldwide build better portfolios and get to better outcomes. I don’t see how a product that has done that won’t continue to grow if people look and adopt new ways to use ETFs to solve their investment challenges.

Democratization of access has been one of those investment challenges ETF helped resolve. Cost is a major part of that, but do you think too much attention is paid to low management fees as a headline number? Is there a better way of thinking about the total cost of ETF ownership?

Anytime you’re evaluating an ETF usage, you have to look at the total cost of ownership. In fact, with the management fee getting cheaper, the other costs become much more significant. If you’re tracking the difference between two funds that charge management fees of 0.04% and 0.05%, respectively, and that’s the only thing you’re looking at, you’re missing the impact.

What’s the spread? What’s the tracking era of the underlying funds? What exposure are you getting on the differences that you know what the right exposure is? Do you know what exposure you want, because they might go in different indexes?

What is the trading costs? Is it commission‑free? What’s the various bid‑ask spread consistency over a period of time?

I think we’re getting to a point where the actual headline cost can be looked at as being relatively low these days. The importance of making sure you’re looking at an informed choice as to, what if those other things become probably more critical today than ever?

What are the common misconceptions about the total cost of ownership?

The easiest thing to do without question is to look at the expense ratio and say, “I’m going to take that one. It’s cheaper.” The harder work is to try and understand. The other things are not as easy to get to. What’s the bid‑ask spread? Well, bid‑ask spreads change based on market trends.

It’s not easy to look. What is your investment horizon? If your investment horizon is shorter term, the actual expense ratio is significantly less to you than cost of those transactions — the cost of getting in and the cost of getting out. If your horizon is 10 years, then that difference might be more important to you.

I don’t think we’re anywhere near enough work done on this. Look at the underlying tracking error. How is the fund tracking versus the benchmark? It is often a mistake to assume that the tracking error, there shouldn’t be a difference by the provider.

Sometimes people take different approaches to how they track. Whether it’s a full replication or if you’re sampling, there are different methodologies of sampling. There’s a lot in there to analyze. You also don’t want to make it so complicated that the investor looks it and says, “This is too complicated. I’m not doing it.”

I think that an institutional investor or a financial adviser who is using a lot of ETFs will need to be on the lookout for tracking error. They would want to make sure what they’re buying for their investment purposes is a fit. A lot of sophisticated investors do question a tracking error out to the 10th decimal place if they see something they don’t understand.

You mentioned that the ETF industry is only scratching the surface in terms of how they can be used by insurers. What are the hurdles?

Insurance companies, like many of the other channels, will take a little bit more time and analysis to get up and going. They have a way they’ve been investing for a number of years. They want to make sure if they decide to incorporate something else, they understand how their portfolio is going to move over in the long term and how it looks from their return standpoint, but also as net capital questions that insurance companies also have to deal with.

Insurers are not all the same. From that perspective, it’s still in the education stage. Some of them have really moved quickly and seeing this as a way to add liquidity to their portfolios. They tend to have large portfolios leaning more towards fixed‑income securities because of the nature of the liabilities they’re trying to match.

I do think looking at how they can incorporate fixed-income ETFs from a liquidity standpoint is something we’ll continue to look at.

Why are the ETFs arguably underrepresented in the largest global asset class, fixed income?

I think that fixed income is developing differently from equities. Let’s not forget that equity ETFs existed for a long time before fixed income came to market.

There are also some misunderstandings in the marketplace. We continue to educate on fixed‑income liquidity.

The ETF is a vehicle that holds fixed‑income securities. If there’s a broad run on fixed‑income securities — which I don’t believe will happen — it will impact mutual funds, ETFs, and other portfolios of fixed income in a similar manner.

Some people think fixed‑income ETFs will create the next crisis in fixed income. If you looked at the ways fixed‑income ETFs have traded to help investors get access during volatile times, they’ve actually helped investors by smoothing out market fluctuations.

We saw that in the high‑yield market at the end of 2015, when we saw some volatility in the high‑yield bond market. Fixed‑income ETFs helped to candidly dampen some of the volatility. They allowed investors to place an investment strategy around their long-term views on the high‑yield bonds.

You are describing an underappreciated positive example of ETFs influencing the high-yield market segment. What ETF product innovation are you cautious about?

Here in the US, I am not a personal investment fan of leveraged and inverse ETFs. My concern about leverage and inversed ETFs is around the education side, about the investor understanding how they work. The education on that just needs to continue.

The leveraged and inverse ETFs do what they say they’re going to do. I just worry that sometimes the average investor may not have done the due diligence to know exactly how leveraged or inverse ETFs might react in an extremely choppy volatile market. Say we are talking about 3x ETFs — if the market gyrates wildly then over a number of days where they’re not going to get the three‑time outcome, but possibly significantly higher or lower returns.

You need to really understand how they work. At the same time, I do not believe leveraged and inverse ETFs cause systemic risk.

A question from an investment choice standpoint is: Do you understand the vehicle well enough to use in your portfolio strategies?

Many people say that we have reached peak ETF mania. What’s your take?

The marketplace will decide that. Because running ETFs is expensive. Everyone who’s doing business is doing business for a return.

If you’re spending a lot on running ETFs and your expenses exceed your revenue for a period of time, you’re not going to be in business.

For an example, look at my firm, State Street Global Advisors. For the last three years now, we have closed more ETFs than we’ve opened. That’s because we’re looking at our lineup. We want to make sure that if we have something in our lineup, we think it belongs in the long term.

In designing sustainable investments, we try and look at what we think the marketplace needs for the long term and that there’s investor demand for it.

We want to answer those needs. But we don’t want to answer the needs by just launching a significant amount of product.

I want to be clear here, though: The ETF marketplace — Canada, the US, and around the globe — is a very democratic marketplace. If you can follow the rules of that marketplace and have a plan and good product idea, you should be able to bring an ETF to market.

Everyone should have the right to bring their innovations  to the marketplace. Let the marketplace decide. The marketplace is very good at vetting out ideas that don’t make sense for investors.

We’ve seen many of those over the years. Some of them I could have called in advance. Some of them I was probably surprised they didn’t survive.

Investor education is near and dear to CFA Institute. You also mentioned its importance a couple of times. How well is the ETF industry as a whole doing here?

If I was talking at the industry level, I would say I don’t think any of us do a good enough job. Yet we’ve all invested millions of dollars in doing this. The sponsors, the large platforms in the US and Canada, have broadly invested money on educating their client base, their financial advisers.

I guess the challenge is we need to continue to teach investors how to package ETFs for the outcomes they’re trying to get to. The positive thing about ETFs is they can be tailored to a portfolio to achieve that outcome. But it requires education to understand the vehicle, to understand the underlying index.

What’s in the index? Is it equities? Is it bonds? Is it derivatives? What’s the actual holding in the fund? Is it fully replicated? Is it samples? What’s the tracking era? Look at all these questions and ask yourself, “How does the ETF vehicle fit in the investment portfolio?”

Ideally education will be accessible to all investors, whether they’re buying it online in their brokerage account for their own personal account, or it’s an institutional investor with significant assets. Part of the solution is to continue educating though different mediums and continue to reinforce it, not just once, not twice, but many times as an industry.

That gets  us to how best to trade ETFs, how best to evaluate ETFs. It’s one thing to teach investors how to evaluate ETFs and quite another is to teach them how best to execute their trade in the marketplace if you’re actually making the trades directly yourself.

At State Street Global Advisors, you have a global vantage point. What are differences among ETFs from country to country?

I think every marketplace is a little different. Investors in every marketplace have been brought up on some home-market biases, and there’s nothing wrong with that. In any case, it’s understanding where those conscious or unconscious biases are from your home-market perspective. You want to think, “Well, what is the right way to invest?”

Let’s take Canada, which features a very different retirement system than the US. This leads to a very different approach to investing. I think you want to look at every marketplace. I’ve spent a lot of time looking at ETF marketplaces around the globe. No one looks the same.

I’ve had many people tell me, “The Australian marketplace looks a lot like the US,” when they got to Australia. I’m like, “This doesn’t look a lot like the US.” Some people say, “Canada and Australia look similar.” I’m like, “Hm-mmmm, yes, but there are still significant differences.”

Frankly, there are significant differences in the advice marketplaces in every country. Some are much more developed than others. Some have different regulations.

I think you have to really go market by market and think, “What’s right for the investor?” That’s why you really need to have local expertise involved.

What developments in the ETF marketplace are you most excited about?

I’m most excited about helping end investors get to better outcomes at lower cost than they were able to two, or three, or five years ago, and definitely 10 or 15 years ago.

Always come back to what is the real purpose for any investment vehicle. Is it to help the investor, whatever investor that is, get to better outcomes? The ETF has grown because investors are choosing to use it in more ways to try and deliver those outcomes.

Whether it’s pension funds that they’re running. their own personal end portfolio, or a financial adviser trying to help hundreds of clients retire with the money they need and have that success — that’s probably what I’m most proud of and what I think will probably drive the future of ETFs.

That’s a terrific exclamation point to our discussion. Thank you very much for your time.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Stephanie Carter

About the Author(s)
Paul Kovarsky, CFA

Paul Kovarsky is a director, Institutional Partnerships, at CFA Institute.

1 thought on “The ETF at 25: Still Scratching the Surface, Says SPDR’s Jim Ross”

  1. Kirk Cornwell says:

    It may only take one “black swan event” to expose the lack of liquidity of ETFs and the lack of liquidity within them. While this may only happen within a category, it may fray the fabric of the industry and force a major rethink of just what’s going on here. It won’t happen until it happens — party on.

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