Episode 18: The Obscure Report That Spawned the ETF Industry

Joe Weisenthal (0:06)

Hello, and welcome to another edition of the Odd Lots podcast. I'm Joseph Weisenthal, managing editor of Bloomberg Markets.

Tracy Alloway (0:14)

And I'm Tracy Alloway, executive editor of Bloomberg Markets.

Joe Weisenthal (0:17)

So Tracy, today we're going to be, it's like a special episode. We're talking to one of our colleagues here at Bloomberg.

Tracy Alloway (0:22)

A special edition.

Joe Weisenthal (0:23)

Of Odd Lots. We're gonna be talking about one of the most important financial innovations of the modern era, wouldn't you say?

Tracy Alloway (0:31)

I would definitely say so, isn't it? Something like a three trillion dollar industry, is that right?

Joe Weisenthal (0:37)

And that industry is the ETF, and I think almost everybody at this point who's aware of markets knows what ETFs are. They're exchange-treated funds.

You can use them to make a bet on the S&P as a whole. You can use them to make a bet on gold, and you can use them to do crazy stuff like make a 3X levered bet on junior gold miners.

Tracy Alloway (1:01)

I do that all the time.

Joe Weisenthal (1:02)

Yeah, of course.

Tracy Alloway (1:02)

But it's like a basket of things, right? And it trades like a single stock on an exchange.

Joe Weisenthal (1:08)

Exactly right. And these ETFs have been hoovering up assets, as you said, trillions of dollars away from traditional funds, from traditional money managers. And it doesn't look like they're slowing down anytime soon.

And not only that, they continue to innovate. So there are more and more new kinds of ETFs all the time.

Tracy Alloway (1:27)

From what humble beginnings did the ETF market come to us?

Joe Weisenthal (1:31)

This is the fascinating thing we're going to discuss with our colleague, Eric Balkounas. He has a new article out in Bloomberg Markets magazine called The ETF Files, and that's based on a new book that he's publishing.

And so it turns out, Eric, thanks for joining us.

Eric Balchunas (1:46)

Thank you for having me.

Joe Weisenthal (1:47)

So the ETF, this monster innovation that's changing how people invest, came out in a weird way. It came out thanks to basically a memo, right?

Eric Balchunas (1:56)

Yeah, memo will be putting it mildly, an 840 page government report is really where the seed for the ETF was found. So what happened was in the 87 crash called Black Monday, right?

Joe Weisenthal (2:08)

1987

Eric Balchunas (2:09)

1987 The worst stock market crash in history.

There was, SEC spent four months writing a report about what happened. They were trying to figure out what really, not the macro events that caused selling, but what exacerbated the sell-off, that it was so brutal, right?

Tracy Alloway (2:25)

Wait, can you tell us what did happen? Because we can't pass up an opportunity to talk portfolio insurance. I'm sorry.

Eric Balchunas (2:31)

Sure. So what they found was when the dark clouds were going over the market, institutions had all started using something called portfolio insurance, which essentially was a strategy that involved shorting futures, right, based on indices, as soon as the stocks they held started hitting a certain level.

So essentially what happened was on that day, there just weren't that many buyers for the people trying to sell insurance.

Then on top of that, you had program traders who were arbitraging the futures to the individual stocks, which involved buying the futures and then selling all 500 or how many of 100 stocks at the same time, right? So what happened was those program traders stepped in and they were putting all the sell orders on the individual stocks. That caused more panic. And all of a sudden, really what you had was all these forces looking to sell individual stocks all at the same time. And that's when you had the crash.

Joe Weisenthal (3:26)

And how much was the crash that day?

Eric Balchunas (3:28)

The crash, it was a 508 point drop, 22% in one day.

Joe Weisenthal (3:33)

Wow.

I mean, we've had like some flash crashes in recent years, but that really puts it into perspective. It also reminds it, you know, we've blamed high-frequency trading and all kinds of stuff on modern flash crashes, but you can get some extraordinary moves it seems about in just about any area.

Eric Balchunas (3:49)

That's right. Yeah.

Joe Weisenthal (3:51)

Okay, so the SEC put out, after several months of studying that crash in 1987, they wrote an 840-page memo. And what was in that memo that led to the ETF?

Tracy Alloway (4:05)

Sure.

Eric Balchunas (4:05)

On chapter three, right, deep into the actual white paper memo, there was something where they talked about if an alternative approach were to be examined. So they used that language. And what they were basically saying was the SEC was thinking that the futures market volatility and sell-off had transmitted to individual stocks. So they thought, you know, if there was only a way to do basket trading, so you didn't hit sell on 500 stocks at once, but you hit sell on a basket and you had market makers and specialists who were able to trade those baskets, it might have provided a buffer in between the futures market in Chicago, which the SEC doesn't have any regulation over, and the individual stocks in New York, which they do.