The Evolution of ETFs
The Evolution of ETFs By Jonathan Citrin | March 31, 2016
With the steady rise of exchange traded funds (ETFs) over the past few decades, there has been constant media and academic focus on all facets of this popular investment vehicle. Through the lens of history, we see the ascent of ETFs had less to do with their actual creation and subsequent development, and much more to do with the evolutionary backdrop of financial theory. The progression of financial theory over the course of the 20th century and investors’ changing views of financial markets created an environment in which ETFs could flourish and become the investment vehicle of the future.
The Invention of the Index
The most famous stock index in the world is the Dow Jones Industrial Average (DJIA). Created by Charles Dow and Edward Jones, the DJIA was a product of Dow, Jones, & Company’s daily market newsletter. Initially intended to lessen the markets’ opacity, the DJIA tracked twelve stocks by 1896 and gave investors an indication of price performance for any given trading day. In addition to the valuable knowledge it provided stock traders at the time, this very first index gave rise to technical analysis, greater market transparency, and investment manager performance comparison to an index. It ultimately commenced the century-long journey toward ETFs.
Stock Picking Takes a Backseat
Despite the invention of the index, the early 20th century in finance was dominated by the Great Depression as well as the work of Benjamin Graham and advancements in fundamental analysis. It was not until 1952, when University of Chicago doctoral student Harry Markowitz published “Portfolio Selection” in the March edition of the Journal of Finance that the next significant development in the progression toward ETFs occurred. In proving that return and risk in a portfolio are intimately intertwined, and putting forth the idea of diversification, Markowitz more or less invented Modern Portfolio Theory (MPT) and therein significantly advanced the principle that an investor’s risk tolerance should be the driving force in constructing a portfolio. This was a powerful moment in ETF evolution: for the first time in market history, investors became more focused on the allocation of assets in their portfolio rather than individual stocks and their relative prices.