As QAS rolls out its new ETF Strategist Tool, I am reminded of some of the history of the incredible growth of this investment vehicle and the people who played a role in this history. For my own part, I was very fortunate to work closely with two of them, both of whom are Wall Street legends.
The late Barton Biggs, director of research at Morgan Stanley as well as chief executive of Morgan Stanley Capital Management, was a visionary for a particular aspect of investing: understanding why clients fire you. Biggs wanted to know what “report card” the clients were going to use when judging his results. In this search he became ever more aware of the role that index benchmarks play in investing. “Yes, you went up, but the S&P went up more.” As institutional investing became dominant, sophisticated performance analytics focused increasingly on the attributes of the performance results. Were the returns the result of merely investing in an index or were they the result of taking specific bets that were either under or over represented in that index. This analysis simultaneously fit in with Biggs’ research role where he became one of the first to think of global investing. The combination of indices and countries helped Barton forge a close relationship with Capital International, a private investment data firm which was the Swiss based arm of Capital Group in Los Angeles. Capital International was essentially building investment indices for every country, playing some of the role S&P did in the US. In 1986 Biggs convinced Morgan Stanley management to purchase Capital International, becoming Morgan Stanley Capital International, or MSCI as is so well known today.
I worked at Morgan Stanley as a portfolio manager in a small group of five including Biggs. Four of us were each given a billion dollars of a five billion dollar portfolio. We each individually had very few limitations, except to make money for our client. To make our freedom work within a constraint, Barton created basically an “inventory fund,” allowing us to sell or buy stocks from him when possible, limiting somewhat our actual transactions in the open market. The process also minimized cross purpose transactions while still giving each portfolio manager maximum freedom. To facilitate his function, Barton had to develop an intricate and accurate awareness of how those stocks played in the index that the client had assigned as our report card.
At one point in my career I had been a portfolio strategist like Biggs and we both created our own sectors to describe the kinds of strategies we were recommending. But there was no standardization. Barton saw this as a both a problem and an opportunity. In 1999 MSCI joined forces with Standard and Poor’s and classified every global stock into one of ten sectors and from there into one of about 120 industries. As compared to the efforts of individual strategists, the world now had a dominant partnership, essentially dictating the sector and industry membership of every stock. This became the major opening for the ETF industry. Until then, ETFs had been mostly limited to replicating the S&P 500 and a small number of other international indices. The flood gates opened for the issuance of sector ETFs.
Eliminating a Middle Man
The sector ETFs came along after I had left Morgan Stanley, but became central when I was working with the firm that the late Martin Zweig helped become a leading institutional investment manager. Marty is best known for coining the phrases, “Don’t fight the Fed” and “Don’t fight the tape.” Our firm had become one of the first to specialize in active asset allocation. I was co-director of research with Marty as one of our products gathered momentum. It essentially was a fund of mutual funds that helped us take advantage of opportunities in stocks and/or bonds as asset classes, depending on the risks that were measured by our quantitative models. One of the problems with this implementation then was that we and our clients were at the mercy of the performance of the individual mutual fund managers. As now, that performance was not very predictable. We started a search for ways to reliably get what we wanted, without the ups and downs of the fund manager. At first we used a new class of funds, actively managed sector mutual funds. Even there the talents or lack thereof of the fund manager made it difficult to insure that our intentions were realized. We got closer to the answer when a small mutual fund company, Rydex, started offering sector funds that were passively managed to just replicate the holdings in a sector. This was better, but soon thereafter the MSCI/S&P work opened the doors for sector ETFs. We became one of the first “ETF strategists.” Even before the sector ETFs we had been among the very first to use ETF-like international funds called “WEBs” and “Country Baskets.”
The early development of ETFs was basically a slicing and dicing of the global stock markets into constituent pieces. We soon got much better implementations of the WEBs and Country Baskets ideas. A real breakthrough from that line of development came with the introduction of broad bond index ETFs and then, similar to equities, more and more subdivision of the bond indices. The ETF concept has been extended now to real estate, currencies and commodities. Prior to ETFs, those who wanted to invest in this palette were not able to because the cost of assembling them made them available only to the mega money managers.
Still another more recent offshoot of this history has been the creation of ETFs that go beyond drilling down to ever smaller slices of the portfolio baskets that define the indices. Instead, these “fundamental” or “smart” ETFs focus on investment attributes. ETFs now allow investing in only small cap growth stocks, or high dividend stocks, or low price earnings stocks, or, even, hedge fund strategies and on endlessly, or so it seems.
In a sense this latest development of smart ETFs brings us back full circle to the beginning of the story. Prior to the concern with performing relatively better than an index (Biggs’ first quest), very few professionals cared what was in an index. Instead they had their own methods for picking stocks or bonds. Today it’s got a fancier name, “outcome oriented” investing.
What a business! What a great journey!
Learn more about QAS ETF Strategist Online at: http://www.qas-service.com/etf.html