From 0 to 100 – a summary of the short but exciting history of ETFs

The idea to make broadly diversified and cost-effective passive investments was already common in the last century. The current acceptance of this asset class has been a long time coming. 

Louis Bachelier and Harry Markowitz are considered the originators of the ETF idea. Bachelier, a mathematician, was already conducting research on the stock market around 1900 and is now regarded as the founder of financial mathematics. However, during his lifetime he was not noticed by the public – partly because it was, as a mathematician, then considered dubious to engage in stock analysis. 

Markowitz’s modern portfolio theory (MPT) gave new impetus

It was only in the 1950s that Harry Markowitz, then a young student, became aware of Bachelier's findings. He further developed Bachelier’s approach and introduced MPT in 1952. Markowitz received the Nobel Prize in Economics in 1990 for his work, which is still used to this day in calculations involving long-term investments.

The core idea behind MPT is as follows: ff you spread your investments across different assets, the risk decreases, while the probability of returns remain the same. It is crucial that the individual assets correlate as little as possible with each other – i.e. that they are as independent as possible. This principle of diversification has become a guide for generations of investment advisors. However, the theory has also been questioned: the financial crises from 2000 onwards showed that even widely diversified portfolios are not immune to losses: equities, bonds, real estate and commodities then came under pressure at the same time. 

The financial world has changed considerably since Markowitz’s time, when there was no electronic trading. Today, markets are globally networked and fragmented. Equities remain similar, but there are many more types of derivatives. Stock exchange transactions can now be carried out from home within seconds. And price fluctuations are many times higher than in the 1950s. 

Nevertheless, one thing is clear: diversification is important, and a broadly-based portfolio generally offers more security than individual investments. However, diversification is not a guarantee against losses.

Costs as an important success factor

In addition to a growing awareness of risk diversification, the burgeoning realisation that professional fund management does not always deliver what it promises has also given a boost to index funds. In 1967, in an experiment conducted by the respected US financial magazine Forbes, editors threw darts at the Wall Street Journal's stock price list in order to form a portfolio. 17 years later, the average return of the Dart Fund was over 9 percent annually, well above that of the S&P500 – something that many professionally managed investment funds had failed to achieve. 

It was in this environment that William Sharpe and Bill Fouse developed the world's first index fund in 1971, the "Samsonite Pension Fund", named after the suitcase heir who had studied with Markowitz. This first index fund contained 1,500 shares listed on the NYSE and its price was determined once a day. Sharpe is the inventor of the ratio 'Sharpe-Ratio' and was awarded the Nobel Prize, together with Markowitz and Merton Miller, in 1990.

The first ETFs came onto the market in the USA in the 1970s. And the investment company State Street Global Advisors constructed the first index fund in 1970.