3 Stock Market Crashes that changed Investing: Origins of MFs & ETFs

Every cloud might have a silver lining, but sometimes it’s very difficult to see that. Especially when the clouds of economy & the stock market crash across the globe. But if the history of investing is anything to go by, these stormy times are invariably followed by some of the most innovative & prosperous times.

In fact, the innovations of mutual funds, ETFs, and the rise of passive investing have all been triggered in the aftermath of major economic crises & destruction of investor wealth. Events that required lawmakers & the entire industry to re-evaluate & reinvent itself. Three events really changed & shaped the world of investing as we know it today:

1929 & The Great Depression – Adoption of Mutual Funds

While the closed-ended mutual fund structure was created in the early 18th century, the first modern-day open-ended mutual fund was established in the US  on 21st March 1924, when the Massachusetts Investors Trust (MITTX) was created. The fund was required to buy back their shares from investors who wished to sell, and with that, the MITTX essentially gave birth to the entire mutual fund industry as we know it today.

Share Certificate of the first modern mutual fund – Massachusetts Investors Trust

However, it was the subsequent stock market crash of 1929 & the resulting Great Depression that put the focus on the then new revolution called mutual funds. The market crash engendered new regulations for the equities market, including the Securities Exchange Act of 1934 which had many safeguards designed to protect investors (like reporting of quarterly filings). These regulations also favoured mutual funds for their inherent diversification.

India got its first mutual fund in 1964 when the Unit Scheme-64 (aka US-64) was launched by the Unit Trust of India (UTI). UTI was established in 1963 by an Act of Parliament, and was set up by the Reserve Bank of India. 

1987 Black Monday Stock Market Crash – Birth of ETFs

ETFs came into the picture many years later, and it’s no surprise that it was another stock market crash that sowed the seeds for another financial innovation. The “Black Monday” crash of 1987 remains the worst day in the history of US stocks, with the markets falling as much as 23% in one-day! Understandably, the US Securities and Exchange Commission (SEC) soon launched an investigation to understand what went wrong.

The New York Times on the day after Black Monday. Source: The New York Times

In the audit process, the SEC realised that there was no single tradable security that represented the broad market – there were futures contracts on the S&P500 index, but nothing in the spot market. Interestingly, the SEC’s final report highlighted that such an instrument would have minimized the impact of the stock market crash. And they even expressed an interest to develop this entirely new instrument.

This caught the attention of the asset management industry – but while the origins of the ETF structure can be traced back to the U.S. SEC’s interest to create a tradable basket of key stocks, the first formal ETF launched was actually not in the United States.

Launched in 1990, the first ever ETF was the Toronto Index Participation Fund (TIP 35)  – it listed on Canada’s Toronto Stock Exchange (TSE) and tracked the performance of the TSE-35 index.

The US got its first ETF in 1993 with the Standard & Poor’s 500 Depository Receipts (SPDRs), which tracked the performance of the S&P500 index. Asia’s first ETF was the Hong Kong Tracker Fund launched 1999, while the Euro STOXX 50 ETF was the first European ETF, launched in 2000.

Interestingly enough, India got its first ETF only a year later in 2001, when Benchmark Mutual Fund launched the Nifty ETF Fund with a defined objective to track the performance of the Nifty-50 index.

2008 Global Financial Crisis – Rise of Passive

When Lehman Brothers collapsed in September 2008, the entire global economy got engulfed in a financial crisis. Markets across the world crashed sooner or later, but in the aftermath once the dust settled, another historic shift happened – more & more investors started questioning the value add of active management.

The most recent stock market crash paved the way for passive investing. The underperformance of active funds combined with the low-cost appeal of passive investing led many investors to switch from or avoid active investing. And ETFs quickly gained popularity over passive mutual funds due to their tradability & even lower costs.

Change in AuM share of Active and Passive Equity Funds in the US

From an AuM of ~700 billion in 2008, U.S. passive funds grown at an incredible 17% annually to reach ~$4.3 trillion as of May 2019 – in fact, history was made then as the AuM of U.S. passive funds matched the AuM of active funds for the first time.

In India, AuM for passive investing & ETFs has grown at a similar trajectory, with pace of growth significantly accelerating post the financial crisis of 2008-2009. From a mere 415 crores back in March 2003, AuM for passive (index funds & ETFs) grew 31% annually to reach 2,053 crores in March 2009.

Since then, AuM in passive funds has grown at a phenomenal rate of 53% annually to reach an impressive 1,44,788 crores as of March 2019 – that’s about 6% of the AuM of the entire MF industry.

Passive investing & ETFs in particular have again come back into focus in 2019 (learn how ETF liquidity is created in India) – while no major crisis triggered this shift, unsurprisingly it again happened due to the underperformance of active funds & the renewed focus on costs. And rightly so.

We do seem to learn from our (and others’) mistakes after all.

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This is the 3rd post in the ETF Education Series. If you are new to ETFs or interested to learn more about them, we recommend reading the entire series:

1. ETF 101 – What is an ETF?
2. ETF Liquidity, Creation, and The Role of Authorised Participants
3. 3 Stock Market Crashes that changed Investing: Origins of MFs & ETF
4. ETFs – Growth & Scope in India

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Have you ever experienced a stock market crash? If so, what did you learn from it – and if not, how are you protecting your portfolio from such crashes? Leave your comments, feedback, and questions below 🙂