To hone the iShares ETF approach, Mr. Kranefuss spent long hours discussing potential problems with Mr. Most, a former commodity trader and product development guru at the American Stock Exchange who died in 2004.
Mr. Most batted down all of Mr. Kranefuss's nightmare scenarios. "He'd say if it was so simple for something to go wrong with this structure as you think, it would have failed already," Mr. Kranefuss recalled.
Getting dozens of new ETFs through the SEC's registration process took months longer than expected, leaving Mr. Kranefuss with an office full of salespeople with nothing to sell.
Competitors were amused. "We kept hearing they were going to be closed down any minute," recalled Mr. Archard, who worked at Vanguard at the time.
Yet when the first 45 iShares funds launched in May 2000, they too quickly caught on, garnering over $2-billion by the summer. In three years, iShares ETF assets surpassed State Street and hit $200-billion after five years.
At Vanguard, executives were initially concerned about the impact ETFs might have on their highly successful indexed mutual fund business. The original ETF and still the largest, State Street's S&P 500 tracking SPDR, was used mainly by rapid traders and hedge funds to implement arbitrage strategies.
Still, CIO Sauter saw a major synergy between mutual funds and related ETFs. He had witnessed first-hand the harm wreaked on mutual funds when too many investors asked for their money back at the same time, as happened after Russia's debt default in 1998.
Fund managers had to sell securities at the worst possible time to raise cash to return to the fleeing customers. The ETF structure, which allowed investors to dump their shares in the secondary market without requiring a fund's managers to sell securities, would relieve that pressure, he believed.
When then-CEO Brennan finally approved Mr. Sauter's plan to create a class of ETF shares for some of Vanguard's existing index mutual funds in 2001, he required that the ETFs trade under a separate brand, VIPERS, in case something went wrong.
It took some years for ETFs to gain traction inside Vanguard. "We went sideways for a while," Mr. Sauter said, noting the firm had collected less than $20-billion of ETF assets in its first few years.
In 2006, Noel Archard jumped from Vanguard, where he headed institutional ETF sales, to Barclays' iShares. The move seemed to confirm market chatter that Vanguard was not truly dedicated to succeeding with ETFs.
Instead, Vanguard doubled down. The VIPERs brand was abandoned and the firm moved to expand its line in fixed income and real estate. With new training programs for advisers and a website overhaul, the renewed sales push worked. Net inflow into Vanguard ETFs shot up from $8.1-billion in 2006 to $26.9-billion in 2009.
The BlackRock acquisition of iShares also coincided with a surge of competition in the ETF arena. Several major money managers that had been ignoring the market, primarily Charles Schwab and Pacific Investment Management or PIMCO, decided to create their own ETF families. And iShares' two main existing competitors, Vanguard and State Street, turned up the pressure with dozens of new funds and lower fees.
More competition is expected in 2011 when the first ETFs arrive from Tacoma, Washington-based Russell, which already manages about $150-billion alongside its popular family of indexes like the Russell 1000 of large cap stocks and Russell 2000 of small caps. It has filed with the Securities and Exchange Commission to start with a slate of 33 funds.
Russell set up its new ETF operation just blocks away from iShares home base in San Francisco's financial district. It's not just the location that is similar. The new unit is run by James Polisson and Andrew Arenberg, two iShares veterans, and other colleagues from their former team.
With its funds still in registration at the SEC, however, Russell declined to comment on its ETF plans.
Schwab also raided the iShares talent pool to staff its ETF operation which opened its first funds a year ago and has over $2-billion in 11 funds so far. The firm kicked off its entry last November with the first offer to let customers trade its ETFs commission free. Brokerage competitors TD Ameritrade and Fidelity Investments have since followed suit with similar free trading offers.
Schwab will expand the line-up next year, aiming at "big slices" not "little niches," Peter Crawford, senior vice president at the firm said. "We want this to grow big - we're not aiming for a hit rate of 50 per cent."
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- Updated September 6 6:36 PM EDT. Delayed by at least 15 minutes.