WEBVTT - The ETF Story 3: The Approval 0:00:06.240 --> 0:00:09.520 This is Trillions presents the h g F Story. I'm 0:00:09.600 --> 0:00:12.560 Joel Weber and I'm the editor of Bloomberg Business Week. 0:00:13.640 --> 0:00:16.320 In our last episode, we left off with Nathan Most 0:00:16.560 --> 0:00:20.040 and Stephen Bloom of Amex, who just conceived an idea 0:00:20.120 --> 0:00:23.360 for a new basket trading product that would track the 0:00:23.560 --> 0:00:27.480 S and P five hundred called Spider. The Amex submitted 0:00:27.480 --> 0:00:31.120 their product to the SEC in but I had to 0:00:31.160 --> 0:00:39.560 wait several years until January for approval. Here's Eric Baltunas, 0:00:39.960 --> 0:00:41.760 four years is still a long time. I mean, you've 0:00:41.760 --> 0:00:45.480 got to think about it. You know, you had Magic 0:00:45.600 --> 0:00:48.760 Johnson was ruling the NBA, George Michael was like all 0:00:48.800 --> 0:00:51.680 over the radio. It was a whole different culture. Right 0:00:52.880 --> 0:00:56.600 by the time the SEC approved it, Nirvana would had 0:00:56.680 --> 0:00:59.560 you know, Grunge was hot, Michael Jordan was running the NBA, 0:00:59.640 --> 0:01:02.840 Basic Lee, the whole kind of culture had changed. That's 0:01:02.840 --> 0:01:05.160 how long they had to wait. So what took the 0:01:05.319 --> 0:01:12.039 SEC so long and what happened during all those years? Well, 0:01:12.120 --> 0:01:14.480 we're going to answer those questions by walking through the 0:01:14.560 --> 0:01:18.880 legal steps needed to gain the SEC's approval. But first, 0:01:19.040 --> 0:01:22.199 let's review what's considered the heartbeat of Spider and every 0:01:22.240 --> 0:01:27.960 other et F the creation redemption process. Bob Tole is 0:01:28.040 --> 0:01:31.440 president of his own E T F consulting company, but 0:01:31.520 --> 0:01:35.320 in the nineties he was vice president at Morgan Stanley 0:01:35.360 --> 0:01:37.759 and he worked with Nate Most to apply this creation 0:01:37.840 --> 0:01:42.680 redemption concept to the new trading vehicle which would become SPY. Now. 0:01:42.760 --> 0:01:45.679 I was from the commodity brillion trading background. I traded 0:01:45.760 --> 0:01:50.040 silver and gold and stuff at Fibro and Morgan Stanley. 0:01:50.440 --> 0:01:54.560 Nate traded commodities in the Pacific, rim leather and some 0:01:54.680 --> 0:01:57.440 other stuff. Right, so we understood how all of this 0:01:57.520 --> 0:02:00.120 worked together, he says. They were bringing the com of 0:02:00.160 --> 0:02:03.280 the world to the equities market. Yeah. If you look 0:02:03.360 --> 0:02:07.440 at a COMEX gold warrant as they called it, right, 0:02:07.920 --> 0:02:11.920 it represented a hundred ounces of gold. Right, that's the 0:02:11.960 --> 0:02:16.000 same size as futures contract. If you stood for delivery 0:02:16.080 --> 0:02:19.959 of the futures contract, you would get this warrant where 0:02:20.000 --> 0:02:22.880 this warehouse receipt if you will, right, and you would 0:02:22.919 --> 0:02:25.440 get collection of a hundred ounces of gold bars and 0:02:25.480 --> 0:02:28.760 had specific purities of specific weight, and you would pay 0:02:28.840 --> 0:02:32.480 for it. Right. But it was packaged. You traded it 0:02:32.520 --> 0:02:35.200 as a futures until an essence of futures was coming 0:02:35.200 --> 0:02:38.119 to maturity. At maturity, if you held the futures contract, 0:02:38.320 --> 0:02:43.120 you would get delivered the gold. So to apply the 0:02:43.160 --> 0:02:47.519 warehouse receipt concept to the basket trading idea to design 0:02:47.600 --> 0:02:50.200 Spider like this, you could have a specific group of 0:02:50.200 --> 0:02:54.320 stocks handed to a custodian in return for shares, and 0:02:54.360 --> 0:02:59.480 those shares could be broken up and sold on an exchange. Plus, 0:02:59.720 --> 0:03:02.359 it could to work inversely, you buy shares on in 0:03:02.480 --> 0:03:06.280 exchange and then hand them to the warehouse custodian and 0:03:06.320 --> 0:03:09.280 get a basket of stocks backed. This idea would need 0:03:09.320 --> 0:03:12.360 to have a virtual warehouse, though, so they partnered with 0:03:12.440 --> 0:03:16.480 State Street as a trustee and custody agent. They had 0:03:16.480 --> 0:03:19.679 the idea nailed down, but they needed some extra help 0:03:19.760 --> 0:03:23.320 getting Spider ready for the SEC. This wasn't just a 0:03:23.360 --> 0:03:25.760 matter of figuring out how the value of commodities can 0:03:25.800 --> 0:03:28.839 be traced using an index. The process also included an 0:03:28.840 --> 0:03:35.960 overwhelmingly complex legal spiderweb. So they had a young lawyer, 0:03:36.000 --> 0:03:39.400 Kathleen Moriarty on their team. She was the one who 0:03:39.480 --> 0:03:41.280 had to work with the SEC a lot and make 0:03:41.280 --> 0:03:44.000 sure they were comfortable with things and work out all 0:03:44.040 --> 0:03:48.240 the details. Remember her Spider Woman. Many years ago, I 0:03:48.320 --> 0:03:50.120 was asked to work on a project that at the 0:03:50.160 --> 0:03:54.200 time was called Spears, not Spider, and it wasn't called 0:03:54.200 --> 0:03:58.600 Spider because people were afraid that a lot of arachnophobes 0:03:58.680 --> 0:04:01.000 would be turned off, and not by the e t F, 0:04:01.400 --> 0:04:04.720 but we ultimately called it Spider. Anyway, Moriarity helped structure 0:04:04.720 --> 0:04:11.800 Spider and submitted to the sec why do they need 0:04:11.880 --> 0:04:14.120 you at all? What is the NETF need a lawyer? 0:04:15.120 --> 0:04:17.760 Because e t f s are registered security is they're 0:04:17.800 --> 0:04:21.040 registered with the Security is an Exchange Commission, and anytime 0:04:21.080 --> 0:04:23.960 you register a security with the Securities Exchange Commission, you 0:04:24.000 --> 0:04:26.840 need a lawyer. And they also wanted me to help 0:04:26.880 --> 0:04:30.919 structure the unit trust in a particular way. Most in 0:04:31.000 --> 0:04:34.839 Bloom wanted the products holdings to reflect changes each day 0:04:34.880 --> 0:04:37.640 to the index, but the lawyers told them that was 0:04:37.680 --> 0:04:41.160 technically managing a fund, which meant they'd have to file 0:04:41.200 --> 0:04:45.440 the product under the Investment Company Act of nineteen as 0:04:45.480 --> 0:04:51.280 a unit investment trust or u I T. Moriarty says 0:04:51.320 --> 0:04:54.000 there was some debate over whether a unit trust or 0:04:54.120 --> 0:04:57.200 mutual fund would be the best vehicle for their product, 0:04:59.480 --> 0:05:03.640 and then somebody said what's the difference, because they're both 0:05:03.680 --> 0:05:07.080 regulated by the forty Act. And one of the differences 0:05:07.200 --> 0:05:09.320 is it's a lot cheaper to run a unit trust 0:05:09.360 --> 0:05:12.160 because it doesn't have a board. It's very limited. It 0:05:12.200 --> 0:05:14.960 can do very limited things, so it doesn't have a 0:05:14.960 --> 0:05:17.520 whole lot of restrictions because it can't hardly do anything 0:05:17.520 --> 0:05:20.240 to begin with. So somebody said, why should we pay 0:05:20.279 --> 0:05:23.840 for a board and all these fancy arrangements when we're 0:05:23.839 --> 0:05:25.920 not going to be doing any of these fancy arrangements. 0:05:26.120 --> 0:05:28.240 Why don't we do a unit trust, which would be cheaper. 0:05:28.240 --> 0:05:30.320 And that's how it came about. So they decide in 0:05:30.320 --> 0:05:32.320 their vehicle and they have to get it ready for 0:05:32.400 --> 0:05:37.120 filing under the forty Act. One of the things that 0:05:37.320 --> 0:05:39.479 is interesting is that an e t F, because it 0:05:39.520 --> 0:05:43.280 trades every day on an exchange, it wasn't technically just 0:05:43.320 --> 0:05:47.080 the clean forty Act approval. It had to get what's 0:05:47.080 --> 0:05:50.000 called an exemption, and that ultimately was part of the 0:05:50.080 --> 0:05:52.520 reason it probably got held up. That the forty Act is, 0:05:52.560 --> 0:05:56.280 by far of the federal securities laws the most prohibitive 0:05:56.320 --> 0:05:59.839 of things. It makes you conform with certain rules and requirements, 0:06:00.080 --> 0:06:03.039 which is not the case for regular common stock. So 0:06:03.480 --> 0:06:07.040 in that way, it's an investor protection and statute worries 0:06:07.080 --> 0:06:10.559 about harming investors and making sure that the things aren't 0:06:10.560 --> 0:06:14.240 done that will harm investors. But there's nothing that's completely safe, 0:06:14.520 --> 0:06:17.960 because everything could be absolutely perfect and all the stocks 0:06:17.960 --> 0:06:21.320 could tank. And so when they're thinking of putting it 0:06:21.320 --> 0:06:23.200 out into this it's sort of like the SEC stamping 0:06:23.200 --> 0:06:27.160 and saying it's ready for Middle America. Deeming a product 0:06:27.200 --> 0:06:29.200 ready for Middle America would be a big leap of 0:06:29.240 --> 0:06:32.400 faith that not everyone at the SEC was ready to 0:06:32.480 --> 0:06:34.960 make with this new product. Yeah, you have to understand, 0:06:35.279 --> 0:06:38.480 this kind of a filing was like a like a 0:06:38.520 --> 0:06:42.320 meteor or a foreign object landing into the SEC. It 0:06:42.400 --> 0:06:44.440 was like nothing they've ever experienced. Remember they were just 0:06:45.040 --> 0:06:48.720 a bit shattered by the seven crash, so they were 0:06:48.720 --> 0:06:54.640 probably a little hesitant to approve anything quickly. Howard Kramer, 0:06:54.680 --> 0:06:57.159 who worked at the SEC at the time, describes the 0:06:57.240 --> 0:06:59.920 mood towards the Spider proposal. There were, you know, the 0:07:00.000 --> 0:07:04.320 are pockets of cautiousness, as with any proposal. I mean, 0:07:05.040 --> 0:07:10.120 remember this is thirty years ago, where when ETFs hadn't existed, 0:07:10.520 --> 0:07:15.240 people had basically stocks, mutual funds, and some people dabbled 0:07:15.240 --> 0:07:17.000 in money market funds and that was pretty much it 0:07:17.600 --> 0:07:20.720 so to to some folks, to some staffers, it was 0:07:20.960 --> 0:07:24.400 a you know, it was it was a product that 0:07:25.440 --> 0:07:27.720 they had to get their arms around. You know, how 0:07:27.720 --> 0:07:30.280 can you have a mutual fund that trades continuously. It's 0:07:30.280 --> 0:07:33.040 not a mutual fund if it does that. And my 0:07:33.120 --> 0:07:36.600 thought was, well, it's that's right, but it's not trying 0:07:36.640 --> 0:07:39.040 to be a mutual fund. It's trying to be a 0:07:39.080 --> 0:07:43.320 new product, and that has aspects significant aspects of the 0:07:43.360 --> 0:07:47.000 mutual fund, but it's different. You'll recall Cramer was on 0:07:47.040 --> 0:07:49.600 the team that wrote the language in the SEC report 0:07:50.040 --> 0:07:52.480 from which most in Bloom got the idea for Spider, 0:07:53.320 --> 0:07:55.760 and he says he and others in the division had 0:07:55.800 --> 0:07:57.840 to do a little convincing to those who were more 0:07:57.840 --> 0:08:00.360 cautious about the product than they were and to why 0:08:00.400 --> 0:08:03.440 we were at one not only enthusiastic about it, but 0:08:03.800 --> 0:08:07.960 felt that it really did not pose concerns and should 0:08:08.000 --> 0:08:11.320 be just gotten off the ground as quickly as we could. 0:08:12.360 --> 0:08:15.320 And a big bonus with Spider was that its structure 0:08:15.360 --> 0:08:18.800 made for significant tax benefits. In the case of Spiders 0:08:18.880 --> 0:08:22.440 or other e T F s. Most of, if not everything, 0:08:22.560 --> 0:08:25.640 is done by exchange and kind. So when somebody says 0:08:26.160 --> 0:08:30.080 the index doesn't track anymore, we're changing the index. They 0:08:30.080 --> 0:08:34.240 don't sell those securities. They deliver them to the person 0:08:34.280 --> 0:08:38.480 who creates them, and in exchange they get the other kind, 0:08:38.679 --> 0:08:42.119 the new kind back. So there is no tax situation 0:08:42.120 --> 0:08:45.600 occurring at the trust level because there's an exemption for 0:08:45.679 --> 0:08:48.240 in kind exchanges. And that was, by the way, an 0:08:48.320 --> 0:08:53.200 unintended consequence. Nobody nobody planned that. One day one of 0:08:53.240 --> 0:08:55.520 the tax people was looking at it and he said, hey, 0:08:55.559 --> 0:08:57.160 you know this, this is going to be a tax 0:08:57.160 --> 0:09:01.160 exempt exchange. This unintended consequence was another big win for 0:09:01.200 --> 0:09:05.559 SPY because no money exchanges hands when shares are created 0:09:05.760 --> 0:09:10.120 or redeemed, the product would not emit capital gains distributions 0:09:10.160 --> 0:09:15.120 the way that mutual funds do. After years of designing 0:09:15.120 --> 0:09:17.760 the structure and tailoring it for SEC approval under the 0:09:17.800 --> 0:09:23.520 forty Act, it's finely greenlit and ready for launch. Everybody 0:09:23.559 --> 0:09:27.480 was excited. It was a big deal. They handed out hats, 0:09:27.559 --> 0:09:31.400 they had, you know, paraphernalia, A big giant spider hanging 0:09:31.440 --> 0:09:34.160 down from look like a Halloween dance. I heard on 0:09:34.200 --> 0:09:36.920 the floor of the exchange and the first day had 0:09:36.920 --> 0:09:39.800 traded a million shares. It was a big hit, seemingly. 0:09:40.280 --> 0:09:44.120 That's a lot, especially back then, and I think people 0:09:44.400 --> 0:09:47.320 were kind of intrigued. Moriarty says they were hoping that 0:09:47.400 --> 0:09:50.200 Spy would get a billion dollars in assets. When we 0:09:50.280 --> 0:09:52.960 launched it on the on the stock exchange, on the AMEX, 0:09:53.160 --> 0:09:55.360 there were probably a hundred people there, you know, on 0:09:55.400 --> 0:09:57.800 the floor, and they were probably the only hundred people 0:09:57.800 --> 0:10:01.680 who knew what this product was. And so it really 0:10:01.760 --> 0:10:05.120 devolved onto a whole bunch of of traders when the 0:10:06.800 --> 0:10:08.840 humans the fright, when it looked like the movie, so 0:10:08.920 --> 0:10:11.600 then it it really was a bunch of brokers and 0:10:11.640 --> 0:10:17.280 traders who would go to individual broker dealers and say, hey, 0:10:17.320 --> 0:10:20.080 we have this new product. Here's what it does. So 0:10:20.120 --> 0:10:24.720 it was really a evangelical sell for quite a while 0:10:24.720 --> 0:10:27.680 because people didn't really know what it was. People, you know, spiders. 0:10:27.720 --> 0:10:30.400 I didn't know what that meant. Et F wasn't invented, 0:10:31.440 --> 0:10:34.400 Yeah that's right. The term E t F wasn't even 0:10:34.480 --> 0:10:37.320 invented yet. That would come a few years later. So 0:10:37.360 --> 0:10:40.280 they gave it the taker Spy and an expense ratio 0:10:40.400 --> 0:10:43.880 of point to exactly the same as the point to 0:10:44.760 --> 0:10:49.120 expense ratio of the Vanguard five index fund, which already 0:10:49.120 --> 0:10:54.560 had six point five billion in assets. Bob Tole says, 0:10:54.600 --> 0:10:57.360 it was priced to compete with that very Vanguard product. 0:10:57.600 --> 0:11:02.080 So if the sp five was twice any, right, they 0:11:02.240 --> 0:11:04.880 did twenty and so that there would be this price 0:11:04.920 --> 0:11:08.880 shift between the two companies. This expense ratio was integral 0:11:09.200 --> 0:11:11.640 in keeping costs low for the e t F and 0:11:11.840 --> 0:11:16.600 ultimately for its long term success in democratizing investing. Next 0:11:16.600 --> 0:11:19.640 time on Trying Presents, we'll learn about other products similar 0:11:19.679 --> 0:11:22.480 to spy and why they didn't see the same success. 0:11:22.679 --> 0:11:25.040 Who who really cares? I mean, I suppose in retrospect 0:11:25.040 --> 0:11:27.560 you can make a good, you know, thriller movie out 0:11:27.559 --> 0:11:30.160 of it, somebody running the briefcase across the tracks kind 0:11:30.160 --> 0:11:33.440 of thing. But but in the end, all of these 0:11:33.440 --> 0:11:36.120 things come down to execution. And I think that's actually 0:11:36.120 --> 0:11:38.840 been the story of ETS for twenty five years, is 0:11:38.880 --> 0:11:49.760 it's always down to execution. Thanks for listening to Trillions Presents. 0:11:50.240 --> 0:11:52.760 Until next time. You can find us on the Bloomberg Terminal, 0:11:52.920 --> 0:11:56.280 Bloomberg dot com, Apple podcasts, and where else you want 0:11:56.280 --> 0:12:00.319 to listen. Trillions Presents is produced by Jordan's Bell with 0:12:00.440 --> 0:12:04.240 production help from Magnus Rokson. Francesco Leviy is the head 0:12:04.280 --> 0:12:09.320 of Bloomberg Podcast. And if you're still wondering about the 0:12:09.520 --> 0:12:12.800 SEC approval process, I have a question because you've been 0:12:12.840 --> 0:12:15.440 approved many times and I'm wondering, does the SEC have 0:12:15.559 --> 0:12:18.960 a big rubber stamp that says forty Act and they 0:12:19.040 --> 0:12:20.480 like put it on the paper when you when you 0:12:20.559 --> 0:12:21.400 finally been approved.