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And further likely evolution.
Exchange-traded funds are an outstanding example of the evolution of new financial products. We trace the history of ETF antecedents-the proto-products that led to the current generation of exchange-traded funds and set the stage for products yet to come. After describing how ETFs were developed and how they work, we speculate on the course evolution will take in producing new varieties of exchange-traded funds.
PORTFOLIO TRADING
The idea of trading an entire portfolio in a single transaction did not originate with the TIPS or SPDRS that are the earliest examples of the modern portfolio-traded-- as-a-share structure. It originated rather with what has come to be known as portfolio trading or program trading.
In the late 1970s and early 1980s, program trading was the then-revolutionary ability to trade an entire portfolio, often a portfolio consisting of all the S&P 500 stocks, with a single order placed at a major brokerage firm. Some modest advances in electronic order entry technology at the New York Stock Exchange and the American Stock Exchange and the availability of large order desks at some major investment banking firms made these early portfolio or program trades possible.
At about the same time, the introduction of S&P 500 index futures contracts at the Chicago Mercantile Exchange provided an arbitrage link between futures contracts and the traded portfolios of stocks. It even became possible, in a trade called an exchange of futures for physicals (EFP), to exchange a stock portfolio position, long or short, for a stock index futures position, long or short.
The effect of all these developments was to make portfolio trading in either cash or futures markets an attractive activity for many trading desks and for many institutional investors. As a logical consequence, there arose interest-one might even say demand-for a readily tradable portfolio or basket product for smaller institutions and individual investors. Futures contracts were relatively large in notional size and the variation margin requirements for carrying a futures contract were cumbersome and relatively expensive for a small investor. Perhaps even more important, there are approximately ten times as many securities salespeople as futures salespeople.
The need for a security, i.e., an SEC-regulated portfolio product, that could be used by individual investors was apparent.
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