1 00:00:06,240 --> 00:00:09,520 Speaker 1: This is Trillions presents the h g F Story. I'm 2 00:00:09,600 --> 00:00:12,560 Speaker 1: Joel Weber and I'm the editor of Bloomberg Business Week. 3 00:00:13,640 --> 00:00:16,320 Speaker 1: In our last episode, we left off with Nathan Most 4 00:00:16,560 --> 00:00:20,040 Speaker 1: and Stephen Bloom of Amex, who just conceived an idea 5 00:00:20,120 --> 00:00:23,360 Speaker 1: for a new basket trading product that would track the 6 00:00:23,560 --> 00:00:27,480 Speaker 1: S and P five hundred called Spider. The Amex submitted 7 00:00:27,480 --> 00:00:31,120 Speaker 1: their product to the SEC in but I had to 8 00:00:31,160 --> 00:00:39,560 Speaker 1: wait several years until January for approval. Here's Eric Baltunas, 9 00:00:39,960 --> 00:00:41,760 Speaker 1: four years is still a long time. I mean, you've 10 00:00:41,760 --> 00:00:45,480 Speaker 1: got to think about it. You know, you had Magic 11 00:00:45,600 --> 00:00:48,760 Speaker 1: Johnson was ruling the NBA, George Michael was like all 12 00:00:48,800 --> 00:00:51,680 Speaker 1: over the radio. It was a whole different culture. Right 13 00:00:52,880 --> 00:00:56,600 Speaker 1: by the time the SEC approved it, Nirvana would had 14 00:00:56,680 --> 00:00:59,560 Speaker 1: you know, Grunge was hot, Michael Jordan was running the NBA, 15 00:00:59,640 --> 00:01:02,840 Speaker 1: Basic Lee, the whole kind of culture had changed. That's 16 00:01:02,840 --> 00:01:05,160 Speaker 1: how long they had to wait. So what took the 17 00:01:05,319 --> 00:01:12,039 Speaker 1: SEC so long and what happened during all those years? Well, 18 00:01:12,120 --> 00:01:14,480 Speaker 1: we're going to answer those questions by walking through the 19 00:01:14,560 --> 00:01:18,880 Speaker 1: legal steps needed to gain the SEC's approval. But first, 20 00:01:19,040 --> 00:01:22,199 Speaker 1: let's review what's considered the heartbeat of Spider and every 21 00:01:22,240 --> 00:01:27,960 Speaker 1: other et F the creation redemption process. Bob Tole is 22 00:01:28,040 --> 00:01:31,440 Speaker 1: president of his own E T F consulting company, but 23 00:01:31,520 --> 00:01:35,320 Speaker 1: in the nineties he was vice president at Morgan Stanley 24 00:01:35,360 --> 00:01:37,759 Speaker 1: and he worked with Nate Most to apply this creation 25 00:01:37,840 --> 00:01:42,680 Speaker 1: redemption concept to the new trading vehicle which would become SPY. Now. 26 00:01:42,760 --> 00:01:45,679 Speaker 1: I was from the commodity brillion trading background. I traded 27 00:01:45,760 --> 00:01:50,040 Speaker 1: silver and gold and stuff at Fibro and Morgan Stanley. 28 00:01:50,440 --> 00:01:54,560 Speaker 1: Nate traded commodities in the Pacific, rim leather and some 29 00:01:54,680 --> 00:01:57,440 Speaker 1: other stuff. Right, so we understood how all of this 30 00:01:57,520 --> 00:02:00,120 Speaker 1: worked together, he says. They were bringing the com of 31 00:02:00,160 --> 00:02:03,280 Speaker 1: the world to the equities market. Yeah. If you look 32 00:02:03,360 --> 00:02:07,440 Speaker 1: at a COMEX gold warrant as they called it, right, 33 00:02:07,920 --> 00:02:11,920 Speaker 1: it represented a hundred ounces of gold. Right, that's the 34 00:02:11,960 --> 00:02:16,000 Speaker 1: same size as futures contract. If you stood for delivery 35 00:02:16,080 --> 00:02:19,959 Speaker 1: of the futures contract, you would get this warrant where 36 00:02:20,000 --> 00:02:22,880 Speaker 1: this warehouse receipt if you will, right, and you would 37 00:02:22,919 --> 00:02:25,440 Speaker 1: get collection of a hundred ounces of gold bars and 38 00:02:25,480 --> 00:02:28,760 Speaker 1: had specific purities of specific weight, and you would pay 39 00:02:28,840 --> 00:02:32,480 Speaker 1: for it. Right. But it was packaged. You traded it 40 00:02:32,520 --> 00:02:35,200 Speaker 1: as a futures until an essence of futures was coming 41 00:02:35,200 --> 00:02:38,119 Speaker 1: to maturity. At maturity, if you held the futures contract, 42 00:02:38,320 --> 00:02:43,120 Speaker 1: you would get delivered the gold. So to apply the 43 00:02:43,160 --> 00:02:47,519 Speaker 1: warehouse receipt concept to the basket trading idea to design 44 00:02:47,600 --> 00:02:50,200 Speaker 1: Spider like this, you could have a specific group of 45 00:02:50,200 --> 00:02:54,320 Speaker 1: stocks handed to a custodian in return for shares, and 46 00:02:54,360 --> 00:02:59,480 Speaker 1: those shares could be broken up and sold on an exchange. Plus, 47 00:02:59,720 --> 00:03:02,359 Speaker 1: it could to work inversely, you buy shares on in 48 00:03:02,480 --> 00:03:06,280 Speaker 1: exchange and then hand them to the warehouse custodian and 49 00:03:06,320 --> 00:03:09,280 Speaker 1: get a basket of stocks backed. This idea would need 50 00:03:09,320 --> 00:03:12,360 Speaker 1: to have a virtual warehouse, though, so they partnered with 51 00:03:12,440 --> 00:03:16,480 Speaker 1: State Street as a trustee and custody agent. They had 52 00:03:16,480 --> 00:03:19,679 Speaker 1: the idea nailed down, but they needed some extra help 53 00:03:19,760 --> 00:03:23,320 Speaker 1: getting Spider ready for the SEC. This wasn't just a 54 00:03:23,360 --> 00:03:25,760 Speaker 1: matter of figuring out how the value of commodities can 55 00:03:25,800 --> 00:03:28,839 Speaker 1: be traced using an index. The process also included an 56 00:03:28,840 --> 00:03:35,960 Speaker 1: overwhelmingly complex legal spiderweb. So they had a young lawyer, 57 00:03:36,000 --> 00:03:39,400 Speaker 1: Kathleen Moriarty on their team. She was the one who 58 00:03:39,480 --> 00:03:41,280 Speaker 1: had to work with the SEC a lot and make 59 00:03:41,280 --> 00:03:44,000 Speaker 1: sure they were comfortable with things and work out all 60 00:03:44,040 --> 00:03:48,240 Speaker 1: the details. Remember her Spider Woman. Many years ago, I 61 00:03:48,320 --> 00:03:50,120 Speaker 1: was asked to work on a project that at the 62 00:03:50,160 --> 00:03:54,200 Speaker 1: time was called Spears, not Spider, and it wasn't called 63 00:03:54,200 --> 00:03:58,600 Speaker 1: Spider because people were afraid that a lot of arachnophobes 64 00:03:58,680 --> 00:04:01,000 Speaker 1: would be turned off, and not by the e t F, 65 00:04:01,400 --> 00:04:04,720 Speaker 1: but we ultimately called it Spider. Anyway, Moriarity helped structure 66 00:04:04,720 --> 00:04:11,800 Speaker 1: Spider and submitted to the sec why do they need 67 00:04:11,880 --> 00:04:14,120 Speaker 1: you at all? What is the NETF need a lawyer? 68 00:04:15,120 --> 00:04:17,760 Speaker 1: Because e t f s are registered security is they're 69 00:04:17,800 --> 00:04:21,040 Speaker 1: registered with the Security is an Exchange Commission, and anytime 70 00:04:21,080 --> 00:04:23,960 Speaker 1: you register a security with the Securities Exchange Commission, you 71 00:04:24,000 --> 00:04:26,840 Speaker 1: need a lawyer. And they also wanted me to help 72 00:04:26,880 --> 00:04:30,919 Speaker 1: structure the unit trust in a particular way. Most in 73 00:04:31,000 --> 00:04:34,839 Speaker 1: Bloom wanted the products holdings to reflect changes each day 74 00:04:34,880 --> 00:04:37,640 Speaker 1: to the index, but the lawyers told them that was 75 00:04:37,680 --> 00:04:41,160 Speaker 1: technically managing a fund, which meant they'd have to file 76 00:04:41,200 --> 00:04:45,440 Speaker 1: the product under the Investment Company Act of nineteen as 77 00:04:45,480 --> 00:04:51,280 Speaker 1: a unit investment trust or u I T. Moriarty says 78 00:04:51,320 --> 00:04:54,000 Speaker 1: there was some debate over whether a unit trust or 79 00:04:54,120 --> 00:04:57,200 Speaker 1: mutual fund would be the best vehicle for their product, 80 00:04:59,480 --> 00:05:03,640 Speaker 1: and then somebody said what's the difference, because they're both 81 00:05:03,680 --> 00:05:07,080 Speaker 1: regulated by the forty Act. And one of the differences 82 00:05:07,200 --> 00:05:09,320 Speaker 1: is it's a lot cheaper to run a unit trust 83 00:05:09,360 --> 00:05:12,160 Speaker 1: because it doesn't have a board. It's very limited. It 84 00:05:12,200 --> 00:05:14,960 Speaker 1: can do very limited things, so it doesn't have a 85 00:05:14,960 --> 00:05:17,520 Speaker 1: whole lot of restrictions because it can't hardly do anything 86 00:05:17,520 --> 00:05:20,240 Speaker 1: to begin with. So somebody said, why should we pay 87 00:05:20,279 --> 00:05:23,840 Speaker 1: for a board and all these fancy arrangements when we're 88 00:05:23,839 --> 00:05:25,920 Speaker 1: not going to be doing any of these fancy arrangements. 89 00:05:26,120 --> 00:05:28,240 Speaker 1: Why don't we do a unit trust, which would be cheaper. 90 00:05:28,240 --> 00:05:30,320 Speaker 1: And that's how it came about. So they decide in 91 00:05:30,320 --> 00:05:32,320 Speaker 1: their vehicle and they have to get it ready for 92 00:05:32,400 --> 00:05:37,120 Speaker 1: filing under the forty Act. One of the things that 93 00:05:37,320 --> 00:05:39,479 Speaker 1: is interesting is that an e t F, because it 94 00:05:39,520 --> 00:05:43,280 Speaker 1: trades every day on an exchange, it wasn't technically just 95 00:05:43,320 --> 00:05:47,080 Speaker 1: the clean forty Act approval. It had to get what's 96 00:05:47,080 --> 00:05:50,000 Speaker 1: called an exemption, and that ultimately was part of the 97 00:05:50,080 --> 00:05:52,520 Speaker 1: reason it probably got held up. That the forty Act is, 98 00:05:52,560 --> 00:05:56,280 Speaker 1: by far of the federal securities laws the most prohibitive 99 00:05:56,320 --> 00:05:59,839 Speaker 1: of things. It makes you conform with certain rules and requirements, 100 00:06:00,080 --> 00:06:03,039 Speaker 1: which is not the case for regular common stock. So 101 00:06:03,480 --> 00:06:07,040 Speaker 1: in that way, it's an investor protection and statute worries 102 00:06:07,080 --> 00:06:10,559 Speaker 1: about harming investors and making sure that the things aren't 103 00:06:10,560 --> 00:06:14,240 Speaker 1: done that will harm investors. But there's nothing that's completely safe, 104 00:06:14,520 --> 00:06:17,960 Speaker 1: because everything could be absolutely perfect and all the stocks 105 00:06:17,960 --> 00:06:21,320 Speaker 1: could tank. And so when they're thinking of putting it 106 00:06:21,320 --> 00:06:23,200 Speaker 1: out into this it's sort of like the SEC stamping 107 00:06:23,200 --> 00:06:27,160 Speaker 1: and saying it's ready for Middle America. Deeming a product 108 00:06:27,200 --> 00:06:29,200 Speaker 1: ready for Middle America would be a big leap of 109 00:06:29,240 --> 00:06:32,400 Speaker 1: faith that not everyone at the SEC was ready to 110 00:06:32,480 --> 00:06:34,960 Speaker 1: make with this new product. Yeah, you have to understand, 111 00:06:35,279 --> 00:06:38,480 Speaker 1: this kind of a filing was like a like a 112 00:06:38,520 --> 00:06:42,320 Speaker 1: meteor or a foreign object landing into the SEC. It 113 00:06:42,400 --> 00:06:44,440 Speaker 1: was like nothing they've ever experienced. Remember they were just 114 00:06:45,040 --> 00:06:48,720 Speaker 1: a bit shattered by the seven crash, so they were 115 00:06:48,720 --> 00:06:54,640 Speaker 1: probably a little hesitant to approve anything quickly. Howard Kramer, 116 00:06:54,680 --> 00:06:57,159 Speaker 1: who worked at the SEC at the time, describes the 117 00:06:57,240 --> 00:06:59,920 Speaker 1: mood towards the Spider proposal. There were, you know, the 118 00:07:00,000 --> 00:07:04,320 Speaker 1: are pockets of cautiousness, as with any proposal. I mean, 119 00:07:05,040 --> 00:07:10,120 Speaker 1: remember this is thirty years ago, where when ETFs hadn't existed, 120 00:07:10,520 --> 00:07:15,240 Speaker 1: people had basically stocks, mutual funds, and some people dabbled 121 00:07:15,240 --> 00:07:17,000 Speaker 1: in money market funds and that was pretty much it 122 00:07:17,600 --> 00:07:20,720 Speaker 1: so to to some folks, to some staffers, it was 123 00:07:20,960 --> 00:07:24,400 Speaker 1: a you know, it was it was a product that 124 00:07:25,440 --> 00:07:27,720 Speaker 1: they had to get their arms around. You know, how 125 00:07:27,720 --> 00:07:30,280 Speaker 1: can you have a mutual fund that trades continuously. It's 126 00:07:30,280 --> 00:07:33,040 Speaker 1: not a mutual fund if it does that. And my 127 00:07:33,120 --> 00:07:36,600 Speaker 1: thought was, well, it's that's right, but it's not trying 128 00:07:36,640 --> 00:07:39,040 Speaker 1: to be a mutual fund. It's trying to be a 129 00:07:39,080 --> 00:07:43,320 Speaker 1: new product, and that has aspects significant aspects of the 130 00:07:43,360 --> 00:07:47,000 Speaker 1: mutual fund, but it's different. You'll recall Cramer was on 131 00:07:47,040 --> 00:07:49,600 Speaker 1: the team that wrote the language in the SEC report 132 00:07:50,040 --> 00:07:52,480 Speaker 1: from which most in Bloom got the idea for Spider, 133 00:07:53,320 --> 00:07:55,760 Speaker 1: and he says he and others in the division had 134 00:07:55,800 --> 00:07:57,840 Speaker 1: to do a little convincing to those who were more 135 00:07:57,840 --> 00:08:00,360 Speaker 1: cautious about the product than they were and to why 136 00:08:00,400 --> 00:08:03,440 Speaker 1: we were at one not only enthusiastic about it, but 137 00:08:03,800 --> 00:08:07,960 Speaker 1: felt that it really did not pose concerns and should 138 00:08:08,000 --> 00:08:11,320 Speaker 1: be just gotten off the ground as quickly as we could. 139 00:08:12,360 --> 00:08:15,320 Speaker 1: And a big bonus with Spider was that its structure 140 00:08:15,360 --> 00:08:18,800 Speaker 1: made for significant tax benefits. In the case of Spiders 141 00:08:18,880 --> 00:08:22,440 Speaker 1: or other e T F s. Most of, if not everything, 142 00:08:22,560 --> 00:08:25,640 Speaker 1: is done by exchange and kind. So when somebody says 143 00:08:26,160 --> 00:08:30,080 Speaker 1: the index doesn't track anymore, we're changing the index. They 144 00:08:30,080 --> 00:08:34,240 Speaker 1: don't sell those securities. They deliver them to the person 145 00:08:34,280 --> 00:08:38,480 Speaker 1: who creates them, and in exchange they get the other kind, 146 00:08:38,679 --> 00:08:42,119 Speaker 1: the new kind back. So there is no tax situation 147 00:08:42,120 --> 00:08:45,600 Speaker 1: occurring at the trust level because there's an exemption for 148 00:08:45,679 --> 00:08:48,240 Speaker 1: in kind exchanges. And that was, by the way, an 149 00:08:48,320 --> 00:08:53,200 Speaker 1: unintended consequence. Nobody nobody planned that. One day one of 150 00:08:53,240 --> 00:08:55,520 Speaker 1: the tax people was looking at it and he said, hey, 151 00:08:55,559 --> 00:08:57,160 Speaker 1: you know this, this is going to be a tax 152 00:08:57,160 --> 00:09:01,160 Speaker 1: exempt exchange. This unintended consequence was another big win for 153 00:09:01,200 --> 00:09:05,559 Speaker 1: SPY because no money exchanges hands when shares are created 154 00:09:05,760 --> 00:09:10,120 Speaker 1: or redeemed, the product would not emit capital gains distributions 155 00:09:10,160 --> 00:09:15,120 Speaker 1: the way that mutual funds do. After years of designing 156 00:09:15,120 --> 00:09:17,760 Speaker 1: the structure and tailoring it for SEC approval under the 157 00:09:17,800 --> 00:09:23,520 Speaker 1: forty Act, it's finely greenlit and ready for launch. Everybody 158 00:09:23,559 --> 00:09:27,480 Speaker 1: was excited. It was a big deal. They handed out hats, 159 00:09:27,559 --> 00:09:31,400 Speaker 1: they had, you know, paraphernalia, A big giant spider hanging 160 00:09:31,440 --> 00:09:34,160 Speaker 1: down from look like a Halloween dance. I heard on 161 00:09:34,200 --> 00:09:36,920 Speaker 1: the floor of the exchange and the first day had 162 00:09:36,920 --> 00:09:39,800 Speaker 1: traded a million shares. It was a big hit, seemingly. 163 00:09:40,280 --> 00:09:44,120 Speaker 1: That's a lot, especially back then, and I think people 164 00:09:44,400 --> 00:09:47,320 Speaker 1: were kind of intrigued. Moriarty says they were hoping that 165 00:09:47,400 --> 00:09:50,200 Speaker 1: Spy would get a billion dollars in assets. When we 166 00:09:50,280 --> 00:09:52,960 Speaker 1: launched it on the on the stock exchange, on the AMEX, 167 00:09:53,160 --> 00:09:55,360 Speaker 1: there were probably a hundred people there, you know, on 168 00:09:55,400 --> 00:09:57,800 Speaker 1: the floor, and they were probably the only hundred people 169 00:09:57,800 --> 00:10:01,680 Speaker 1: who knew what this product was. And so it really 170 00:10:01,760 --> 00:10:05,120 Speaker 1: devolved onto a whole bunch of of traders when the 171 00:10:06,800 --> 00:10:08,840 Speaker 1: humans the fright, when it looked like the movie, so 172 00:10:08,920 --> 00:10:11,600 Speaker 1: then it it really was a bunch of brokers and 173 00:10:11,640 --> 00:10:17,280 Speaker 1: traders who would go to individual broker dealers and say, hey, 174 00:10:17,320 --> 00:10:20,080 Speaker 1: we have this new product. Here's what it does. So 175 00:10:20,120 --> 00:10:24,720 Speaker 1: it was really a evangelical sell for quite a while 176 00:10:24,720 --> 00:10:27,680 Speaker 1: because people didn't really know what it was. People, you know, spiders. 177 00:10:27,720 --> 00:10:30,400 Speaker 1: I didn't know what that meant. Et F wasn't invented, 178 00:10:31,440 --> 00:10:34,400 Speaker 1: Yeah that's right. The term E t F wasn't even 179 00:10:34,480 --> 00:10:37,320 Speaker 1: invented yet. That would come a few years later. So 180 00:10:37,360 --> 00:10:40,280 Speaker 1: they gave it the taker Spy and an expense ratio 181 00:10:40,400 --> 00:10:43,880 Speaker 1: of point to exactly the same as the point to 182 00:10:44,760 --> 00:10:49,120 Speaker 1: expense ratio of the Vanguard five index fund, which already 183 00:10:49,120 --> 00:10:54,560 Speaker 1: had six point five billion in assets. Bob Tole says, 184 00:10:54,600 --> 00:10:57,360 Speaker 1: it was priced to compete with that very Vanguard product. 185 00:10:57,600 --> 00:11:02,080 Speaker 1: So if the sp five was twice any, right, they 186 00:11:02,240 --> 00:11:04,880 Speaker 1: did twenty and so that there would be this price 187 00:11:04,920 --> 00:11:08,880 Speaker 1: shift between the two companies. This expense ratio was integral 188 00:11:09,200 --> 00:11:11,640 Speaker 1: in keeping costs low for the e t F and 189 00:11:11,840 --> 00:11:16,600 Speaker 1: ultimately for its long term success in democratizing investing. Next 190 00:11:16,600 --> 00:11:19,640 Speaker 1: time on Trying Presents, we'll learn about other products similar 191 00:11:19,679 --> 00:11:22,480 Speaker 1: to spy and why they didn't see the same success. 192 00:11:22,679 --> 00:11:25,040 Speaker 1: Who who really cares? I mean, I suppose in retrospect 193 00:11:25,040 --> 00:11:27,560 Speaker 1: you can make a good, you know, thriller movie out 194 00:11:27,559 --> 00:11:30,160 Speaker 1: of it, somebody running the briefcase across the tracks kind 195 00:11:30,160 --> 00:11:33,440 Speaker 1: of thing. But but in the end, all of these 196 00:11:33,440 --> 00:11:36,120 Speaker 1: things come down to execution. And I think that's actually 197 00:11:36,120 --> 00:11:38,840 Speaker 1: been the story of ETS for twenty five years, is 198 00:11:38,880 --> 00:11:49,760 Speaker 1: it's always down to execution. Thanks for listening to Trillions Presents. 199 00:11:50,240 --> 00:11:52,760 Speaker 1: Until next time. You can find us on the Bloomberg Terminal, 200 00:11:52,920 --> 00:11:56,280 Speaker 1: Bloomberg dot com, Apple podcasts, and where else you want 201 00:11:56,280 --> 00:12:00,319 Speaker 1: to listen. Trillions Presents is produced by Jordan's Bell with 202 00:12:00,440 --> 00:12:04,240 Speaker 1: production help from Magnus Rokson. Francesco Leviy is the head 203 00:12:04,280 --> 00:12:09,320 Speaker 1: of Bloomberg Podcast. And if you're still wondering about the 204 00:12:09,520 --> 00:12:12,800 Speaker 1: SEC approval process, I have a question because you've been 205 00:12:12,840 --> 00:12:15,440 Speaker 1: approved many times and I'm wondering, does the SEC have 206 00:12:15,559 --> 00:12:18,960 Speaker 1: a big rubber stamp that says forty Act and they 207 00:12:19,040 --> 00:12:20,480 Speaker 1: like put it on the paper when you when you 208 00:12:20,559 --> 00:12:21,400 Speaker 1: finally been approved.