Editor’s Note: This Q&A has been republished in full with permission from ETF BILD.
ETF BILD was formed to stimulate discussion on the business of ETFs, and recently we had the pleasure of sitting down with three of the earliest innovators in the ETF industry, including our own ETF BILD co-founder John Jacobs, to capture their insights on what inspired them in the early days of ETFs and what is driving current and future innovation in the ETF industry.
Joining us are:
- Bruce Bond – Founder of PowerShares, current President of Innovator ETFs
- John Jacobs – Founder of Nasdaq-100 Index (QQQ), current Distinguished Policy Fellow and Executive Director of Georgetown University
- Lee Kranefuss – Founder of iShares, Founding Partner at The Kranefuss Group, LLC.
ETF BILD: You were one of the early innovators in the ETF industry. What did you see back then as the opportunity? How did you execute on that vision?
When John Southard and I founded PowerShares in 2002, the ETF vehicle was less than 10 years old and all of the ETFs in existence were market-cap weighted. So, while the industry was quite young, we felt there was an opportunity to create better ETFs that weighted their underlying stocks based on investment merit rather than by size. To carry out this vision, we worked closely with the American Stock Exchange to build an “intelligent” index that the first PowerShares Dynamic Market ETF (PWC) would track. We branded the index “the Intellidex” and marketed PowerShares as “leading the Intelligent ETF Revolution.”
Executing a vision like intelligent ETFs took a tremendous amount of education and distribution. In 2002, very few people knew what an ETF was, let alone understood why the ones that currently existed should be improved upon. Launching PowerShares on the heels of the tech bubble helped our cause. By the time we arrived, the Nasdaq-100 ETF (QQQ) was the most actively traded security in the world, but its reputation had been damaged by the rise and fall of several heavily-weighted constituents (technology companies). This clearly illustrated that perhaps market capitalization is not the best measure of a company’s value. It sounds rudimentary now but in 2002, these were fighting words to ETF traditionalists.
Nasdaq looked at the ETF space in 1997, although they were not called ETFs then, as an opportunity to create a Nasdaq-branded financial product to enable Nasdaq to interact directly with individuals, institutional investors and traders. Up until that point, Nasdaq always went through an intermediary, whether it was trying to reach shareholders through Nasdaq-listed companies or trying to attract investors through Nasdaq market makers and market participants. We thought that ETFs would be a unique way to influence investor perceptions about Nasdaq and drive positive awareness and attitude, therefore helping Nasdaq in our competitive positioning. We quickly realized that there was a tremendous financial opportunity as well in the area of index products that could help all Nasdaq businesses and be self-sustaining financially. The Global Information Services (GIS) business at Nasdaq today, which contains indexes, data and analytics, is the most profitable business at Nasdaq, and the same holds true at the LSE Group for their GIS unit, which contains FTSE Russell, data and analytics.
We decided not to license the first ETF (QQQ on the Nasdaq-100 index), but rather we created our own fund company similar to the model that the American Stock Exchange followed to create SPY on the S&P 500 Index. We then undertook a three-pronged approach to growing the business. We built out the legacy index platform and operations group to allow for the creation and dissemination of multiple indexes; we separated index data out from the exchange data feed to create separate entitlements and a business development function to work with product sponsors to judiciously license and create index products across multiple channels to reach investors and traders from the most conservative retail investor to the most sophisticated futures trader.
At the time (1998), I was heading strategy at BGI. We were well aware that the largest institutions (with staff and resources to do the work) had come to realize that they were paying too much to and getting too little from most active managers. Worse yet, when they looked across the portfolio they discovered that having large numbers of active managers led to a net outcome that was awfully close to an index fund but with a lot of work and fees. The managers doing well got cancelled out by the ones doing poorly who held the “other” stocks in the index.
We realized the benefits of low-cost and, in the individual market, highly tax-efficient investments as markets that were severely underpenetrated and undermarketed. As the world’s largest indexer, ETFs made all the sense in the world and let us “break bulk.” We could manage a large central fund, with most investors buying and selling their shares on the secondary market, and we would be running what we always ran: large, relatively static and low-cost index funds.
ETF BILD: How different is the industry today versus your original vision of the industry? What has surprised you the most?
We didn’t necessarily have a grand vision for the ETF industry as a whole when I founded PowerShares. We definitely had a clear vision for our firm, which at the time was to build more intelligent ETFs than what currently existed. In terms of brand strategy, you can either be the biggest and the best “something,” or you can innovate, subvert a category and create a new way of thinking. This is what we were doing through PowerShares: increasing people’s perception of what the ETF could actually deliver. iShares, Vanguard and State Street had all but tied up the passive ETF space. We had to create an entirely new category of ETFs and own that new space if we were going to compete with the big three. Looking back, I think we were successful. The PowerShares Dynamic Market ETF (PWC) can be viewed as the cornerstone of the smart beta ETF space, which has seen tremendous growth since its humble beginnings in 2002.
Along those lines, I think what has surprised me the most is the phenomenal growth and proliferation of the smart beta ETF space. In 2002, I never imagined the space would top U.S. $1 trillion, which it did at the end of 2017. I think it shows that investors are still seeking cheaper alternatives to active management in a more methodical way.
The industry has become dominated by a handful of mega-indexers and mega-sponsors today. Although not necessarily surprising, it happened relatively quickly. The concern here is that it may be harder to innovate and get new products to market. In addition, the changes in market structure at the exchanges (primarily in the U.S.) has been a big, behind-the-scenes change for the industry. The end of the specialist system, although very good from an overall market liquidity, quality and competitive standpoint, also ended the most stable supply of new product seed capital. The specialist system did allow for a larger seed capital commitment by market participants in exchange for a monopoly on trading.
We launched 40 funds to start. We believed the market, which includes institutional uses such as traders who need to hedge, funds that needed to equitize cash, etc., needed the basic slices from the big providers. For example, for both Russell and S&P we wanted to offer every slice of U.S. large-, mid- and small-cap as well as growth and value cuts of each. We also saw the need for sectors and international exposure at the country, region and development level (e.g., emerging vs. frontier markets).
We saw ETFs as a better index fund that gave you pinpoint precision. We thought that we would learn from customers and come up with maybe 100 ETFs over time.
What we did not foresee, which I think is a case of turning wine back into grapes in many cases, was the attempt to keep trying to make ETFs more “active.” Suddenly, there were lots of products claiming to outperform the index fund based on some proprietary selection or trading strategy (and at a higher cost). I think the thousands of ETFs out there now – many trying to claim to be active in some way – undermines the key benefits: broad, diversified exposure, low-cost and highly tax-efficient building blocks.
ETF BILD: Where do you see the opportunity in today’s industry?
To me, the opportunity will come through two channels: innovation and regulation. We were fortunate to be part of leading several ETF innovations early on (e.g., smart beta, fixed income, active, commodity). Since those days, we have seen tremendous asset growth but also a high level of product proliferation. Most of these products fit into one of the aforementioned categories. I think some of the larger passive products will continue to see growth; however, we have seen many product launches fail to garner assets and subsequently close due to lack of demand. To me, if ETF issuers are going to succeed in today’s proliferated market, their products have to be innovative and either serve investors’ unmet needs or make things easier and/or lower cost for them.