Anyone would think the exchange traded fund is a new phenomenon, such is the rush of interest shown by investment professionals. In the past month, Europe has witnessed the launch of not just its first, but also its second and third ETFs.

Asia, too, has started in the past six months to host ETFs. In the US, the home of ETFs, fund managers have plans to launch more than 50 new funds this year alone - in effect, nearly tripling the current figure of about 30 funds.

Yet, the spate of new ETFs conceals the long genesis of the hybrid investment vehicle designed to combine the virtues of the share and the mutual fund. The first ETF, Standard & Poors' Depositary Receipt (SPDR), or Spider, was born in 1993.

But, as Nate Most, a former head of product development at the American Stock Exchange (Amex), and the recognised architect of the ETF, explains, the story begins long before that.

In 1986, Amex was struggling to maintain its equity business in the face of stiff competition from the New York Stock Exchange and Nasdaq.

r Most, spotting the growing popularity of index-tracking mutual funds, proposed the idea of attracting these funds to list on Amex. He went to see Jack Bogle, head of Vanguard, one of the largest fund managers.

But Mr Bogle declined the invitation. "He told me," recalls Mr Most, "that 'your traders would run up my expenses by going in and out of the fund'."

Not deterred, Mr Most went back to the drawing board, and, with the help of State Street, the Boston-based bank, came up with the structure for the Spider, which could be listed on the exchange but traded like a security.

This became financially viable shortly after the launch seven years ago, according to State Street. Like subsequent ETFs, it struggled to grow, and in the first five years, all the funds amassed little over £9bn, barely a fifth of the total size of the current market.

The ETFs have not been helped by the inventors' choice of an arcane and acronymic language: if SPDR is bad, so too are "optimised portfolios as listed securities" and "listed diversified return securities" (LDRS).

arketing executives have been hard-pressed to rebrand the funds: SPDR as Spiders, optimised portfolios as Opals, and LDRS as Leaders.

But clever branding does not explain the sudden rise of the ETF. The real reason is the extraordinary success of index funds, as active fund managers have struggled to match, let alone beat, the stock market indices. More and more investors have switched into index funds, underpinning EFT performance.





In the past five years, the S&P 500, which the Spider tracks, has returned more than 25 per cent; and the stunning growth of the stock markets has helped catapult the Vanguard 500 to more than $100bn of assets.

Another factor was that ETFs were not used merely as an investment vehicle. "I thought the ETF would be used simply as an alternative to mutual funds," says Mr Most. Yet, ETFs are also being deployed as a kind of derivative, especially by small investors who are either nervous of the 'D' word, or who cannot afford to use derivatives in an asset allocation strategy.

This has promoted its tradability which, in turn, has caught the eye of various stock exchanges, in the US, Europe and elsewhere.

Having transformed the fortunes of Amex, many European exchanges are hoping the ETF will have the same effect on the other side of the Atlantic. Launching an ETF requires considerable co-operation with numerous parties: the exchange, the fund manager, the custodian, the index provider, the clearing depository, and, of course, the regulator.

To start the Spider, says Mr Most, "we had to get exemptions from virtually everywhere... and it took almost a year". It would have been longer if the US regulator, the SEC, had not just granted specific exemptions to the Index Trust SuperUnit, a hedging vehicle for insurance companies.

In Europe, there was no comparable precedent. Morgan Stanley launched the European-listed Opals in 1993, based on various MSCI indices.

But, to do so, it took advantage of the less restrictive regulatory environment in Luxembourg. The regulatory hurdle chiefly explains why it took seven years to launch ETFs in Europe. Now they have arrived, the great hope is that they can transform the investment industry.

In the US, the rush of popularity in the late 1990s sparked the creation of several new ETFs: those linked to the Dow Industrials, the S&P MidCap 400, the S&P Select Sectors and the Nasdaq 100. The same is expected in Europe.

Both Merrill Lynch, which launched Europe's first fund on the Deutsche Borse, and Barclays Global Investors, which launched the UK's first fund, have plans for more new funds this year, tracking different indices.

The key selling point is the ETF's low cost. As an index tracker, it charges less than active funds. But it derives further cost-savings by using an "in kind" creation and redemption structure, which eliminates most of the costs of buying and selling securities.

This means it costs less than the typical index-tracking fund: the Spider charges just 12 basis points for management fees, whereas the fees of a standard index tracking fund can be as much as 100 basis points.

With the speed of development anticipated for ETFs, fund managers are already planning the launch of more exotic ones: enhanced index, fixed income, multiple class, and those with cross listings in exchanges around the world. There is even talk of actively managed ETFs.

As it is, the index-tracking ETF, with its low expense ratio, is predicted to challenge the dominance of the mutual fund and the open-ended investment company (OEIC).

But if it strays on to the territory of active managers, there could be an almighty war for customers, especially in the retail market. Nate Most, who first battled hard for ETFs nearly 15 years ago, thinks the active ETF is a possibility - but there are practical problems.

"I'm not sure what the regulators would make of it," he says. The essence of the ETF is the arbitrage, which forces fund managers to be completely transparent about the composition of their funds.

"If you're hiding any part of it, they would have a problem. So will the active ETF ever happen? "I don't know," says Mr Most.


Managed funds face threat
Number of new funds set to rise
Racing ahead of expectations