The Evolution of ETFs

March 31, 2016 — 11:05 AM EDT

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.

Index Investing Gains Support

Armed with indexes such as the DJIA and new knowledge of the tradeoff between risk and return in a portfolio, an increasing number of financial theorists in the second half of the 20th century began discounting stock picking and more heavily researching the movement of major market indices. In 1965 and throughout the 1970s, Eugene Fama presented and supported the Efficient Market Hypothesis (EMH). This theory argues that stock prices reflect all available information at any given time; it is not possible to know something the market does not — if information is available, it is immediately factored into a stock’s price. According to the EMH, stock picking is without merit.

Such a development only furthered a desire for an investment vehicle like ETFs – one that would allow investors to invest in the efficient market itself. Dow and Jones created the index, and Markowitz took the emphasis off of stock picking based on price and onto selecting assets based on risk and return demands in a portfolio. Then Fama and the EMH, in calculating it is not possible to outsmart the market, effectively confirmed the 20th century as the era that invented index investing. All that was needed was a means (i.e. an investment product) that enabled investors to buy and sell entire markets at once.

The Bottom Line

The fundamental financial theories of the past century such as the Efficient Market Hypothesis and Modern Portfolio Theory shaped the way we approach investing and made it possible for ETFs to emerge as a leading investment vehicle. It is also important to note that, parallel to the 20th-century progression of financial theory, behavioral psychology was also experiencing significant developments. 

 A growing awareness of neuroscience and how emotion affects rational decision-making pushed even those who disagree with market efficiency toward the non-human based approach of index investing using ETFs; whether markets are efficient or not, stock picking is innately flawed when one factors the ever-present nature of emotion in every decision we make. And although stock picking still comprises a majority of investor behavior, behavioral finance dealt a knockout blow to the business of conventional portfolio management. In time, with a century of market theory to support their use, ETFs should continue to rise in popularity, and it will become increasingly more difficult for stock pickers to find support for their craft.