Speaker 1: This is Trillions presents the h g F Story. I'm
Speaker 1: Joel Weber and I'm the editor of Bloomberg Business Week.
Speaker 1: In our last episode, we left off with Nathan Most
Speaker 1: and Stephen Bloom of Amex, who just conceived an idea
Speaker 1: for a new basket trading product that would track the
Speaker 1: S and P five hundred called Spider. The Amex submitted
Speaker 1: their product to the SEC in but I had to
Speaker 1: wait several years until January for approval. Here's Eric Baltunas,
Speaker 1: four years is still a long time. I mean, you've
Speaker 1: got to think about it. You know, you had Magic
Speaker 1: Johnson was ruling the NBA, George Michael was like all
Speaker 1: over the radio. It was a whole different culture. Right
Speaker 1: by the time the SEC approved it, Nirvana would had
Speaker 1: you know, Grunge was hot, Michael Jordan was running the NBA,
Speaker 1: Basic Lee, the whole kind of culture had changed. That's
Speaker 1: how long they had to wait. So what took the
Speaker 1: SEC so long and what happened during all those years? Well,
Speaker 1: we're going to answer those questions by walking through the
Speaker 1: legal steps needed to gain the SEC's approval. But first,
Speaker 1: let's review what's considered the heartbeat of Spider and every
Speaker 1: other et F the creation redemption process. Bob Tole is
Speaker 1: president of his own E T F consulting company, but
Speaker 1: in the nineties he was vice president at Morgan Stanley
Speaker 1: and he worked with Nate Most to apply this creation
Speaker 1: redemption concept to the new trading vehicle which would become SPY. Now.
Speaker 1: I was from the commodity brillion trading background. I traded
Speaker 1: silver and gold and stuff at Fibro and Morgan Stanley.
Speaker 1: Nate traded commodities in the Pacific, rim leather and some
Speaker 1: other stuff. Right, so we understood how all of this
Speaker 1: worked together, he says. They were bringing the com of
Speaker 1: the world to the equities market. Yeah. If you look
Speaker 1: at a COMEX gold warrant as they called it, right,
Speaker 1: it represented a hundred ounces of gold. Right, that's the
Speaker 1: same size as futures contract. If you stood for delivery
Speaker 1: of the futures contract, you would get this warrant where
Speaker 1: this warehouse receipt if you will, right, and you would
Speaker 1: get collection of a hundred ounces of gold bars and
Speaker 1: had specific purities of specific weight, and you would pay
Speaker 1: for it. Right. But it was packaged. You traded it
Speaker 1: as a futures until an essence of futures was coming
Speaker 1: to maturity. At maturity, if you held the futures contract,
Speaker 1: you would get delivered the gold. So to apply the
Speaker 1: warehouse receipt concept to the basket trading idea to design
Speaker 1: Spider like this, you could have a specific group of
Speaker 1: stocks handed to a custodian in return for shares, and
Speaker 1: those shares could be broken up and sold on an exchange. Plus,
Speaker 1: it could to work inversely, you buy shares on in
Speaker 1: exchange and then hand them to the warehouse custodian and
Speaker 1: get a basket of stocks backed. This idea would need
Speaker 1: to have a virtual warehouse, though, so they partnered with
Speaker 1: State Street as a trustee and custody agent. They had
Speaker 1: the idea nailed down, but they needed some extra help
Speaker 1: getting Spider ready for the SEC. This wasn't just a
Speaker 1: matter of figuring out how the value of commodities can
Speaker 1: be traced using an index. The process also included an
Speaker 1: overwhelmingly complex legal spiderweb. So they had a young lawyer,
Speaker 1: Kathleen Moriarty on their team. She was the one who
Speaker 1: had to work with the SEC a lot and make
Speaker 1: sure they were comfortable with things and work out all
Speaker 1: the details. Remember her Spider Woman. Many years ago, I
Speaker 1: was asked to work on a project that at the
Speaker 1: time was called Spears, not Spider, and it wasn't called
Speaker 1: Spider because people were afraid that a lot of arachnophobes
Speaker 1: would be turned off, and not by the e t F,
Speaker 1: but we ultimately called it Spider. Anyway, Moriarity helped structure
Speaker 1: Spider and submitted to the sec why do they need
Speaker 1: you at all? What is the NETF need a lawyer?
Speaker 1: Because e t f s are registered security is they're
Speaker 1: registered with the Security is an Exchange Commission, and anytime
Speaker 1: you register a security with the Securities Exchange Commission, you
Speaker 1: need a lawyer. And they also wanted me to help
Speaker 1: structure the unit trust in a particular way. Most in
Speaker 1: Bloom wanted the products holdings to reflect changes each day
Speaker 1: to the index, but the lawyers told them that was
Speaker 1: technically managing a fund, which meant they'd have to file
Speaker 1: the product under the Investment Company Act of nineteen as
Speaker 1: a unit investment trust or u I T. Moriarty says
Speaker 1: there was some debate over whether a unit trust or
Speaker 1: mutual fund would be the best vehicle for their product,
Speaker 1: and then somebody said what's the difference, because they're both
Speaker 1: regulated by the forty Act. And one of the differences
Speaker 1: is it's a lot cheaper to run a unit trust
Speaker 1: because it doesn't have a board. It's very limited. It
Speaker 1: can do very limited things, so it doesn't have a
Speaker 1: whole lot of restrictions because it can't hardly do anything
Speaker 1: to begin with. So somebody said, why should we pay
Speaker 1: for a board and all these fancy arrangements when we're
Speaker 1: not going to be doing any of these fancy arrangements.
Speaker 1: Why don't we do a unit trust, which would be cheaper.
Speaker 1: And that's how it came about. So they decide in
Speaker 1: their vehicle and they have to get it ready for
Speaker 1: filing under the forty Act. One of the things that
Speaker 1: is interesting is that an e t F, because it
Speaker 1: trades every day on an exchange, it wasn't technically just
Speaker 1: the clean forty Act approval. It had to get what's
Speaker 1: called an exemption, and that ultimately was part of the
Speaker 1: reason it probably got held up. That the forty Act is,
Speaker 1: by far of the federal securities laws the most prohibitive
Speaker 1: of things. It makes you conform with certain rules and requirements,
Speaker 1: which is not the case for regular common stock. So
Speaker 1: in that way, it's an investor protection and statute worries
Speaker 1: about harming investors and making sure that the things aren't
Speaker 1: done that will harm investors. But there's nothing that's completely safe,
Speaker 1: because everything could be absolutely perfect and all the stocks
Speaker 1: could tank. And so when they're thinking of putting it
Speaker 1: out into this it's sort of like the SEC stamping
Speaker 1: and saying it's ready for Middle America. Deeming a product
Speaker 1: ready for Middle America would be a big leap of
Speaker 1: faith that not everyone at the SEC was ready to
Speaker 1: make with this new product. Yeah, you have to understand,
Speaker 1: this kind of a filing was like a like a
Speaker 1: meteor or a foreign object landing into the SEC. It
Speaker 1: was like nothing they've ever experienced. Remember they were just
Speaker 1: a bit shattered by the seven crash, so they were
Speaker 1: probably a little hesitant to approve anything quickly. Howard Kramer,
Speaker 1: who worked at the SEC at the time, describes the
Speaker 1: mood towards the Spider proposal. There were, you know, the
Speaker 1: are pockets of cautiousness, as with any proposal. I mean,
Speaker 1: remember this is thirty years ago, where when ETFs hadn't existed,
Speaker 1: people had basically stocks, mutual funds, and some people dabbled
Speaker 1: in money market funds and that was pretty much it
Speaker 1: so to to some folks, to some staffers, it was
Speaker 1: a you know, it was it was a product that
Speaker 1: they had to get their arms around. You know, how
Speaker 1: can you have a mutual fund that trades continuously. It's
Speaker 1: not a mutual fund if it does that. And my
Speaker 1: thought was, well, it's that's right, but it's not trying
Speaker 1: to be a mutual fund. It's trying to be a
Speaker 1: new product, and that has aspects significant aspects of the
Speaker 1: mutual fund, but it's different. You'll recall Cramer was on
Speaker 1: the team that wrote the language in the SEC report
Speaker 1: from which most in Bloom got the idea for Spider,
Speaker 1: and he says he and others in the division had
Speaker 1: to do a little convincing to those who were more
Speaker 1: cautious about the product than they were and to why
Speaker 1: we were at one not only enthusiastic about it, but
Speaker 1: felt that it really did not pose concerns and should
Speaker 1: be just gotten off the ground as quickly as we could.
Speaker 1: And a big bonus with Spider was that its structure
Speaker 1: made for significant tax benefits. In the case of Spiders
Speaker 1: or other e T F s. Most of, if not everything,
Speaker 1: is done by exchange and kind. So when somebody says
Speaker 1: the index doesn't track anymore, we're changing the index. They
Speaker 1: don't sell those securities. They deliver them to the person
Speaker 1: who creates them, and in exchange they get the other kind,
Speaker 1: the new kind back. So there is no tax situation
Speaker 1: occurring at the trust level because there's an exemption for
Speaker 1: in kind exchanges. And that was, by the way, an
Speaker 1: unintended consequence. Nobody nobody planned that. One day one of
Speaker 1: the tax people was looking at it and he said, hey,
Speaker 1: you know this, this is going to be a tax
Speaker 1: exempt exchange. This unintended consequence was another big win for
Speaker 1: SPY because no money exchanges hands when shares are created
Speaker 1: or redeemed, the product would not emit capital gains distributions
Speaker 1: the way that mutual funds do. After years of designing
Speaker 1: the structure and tailoring it for SEC approval under the
Speaker 1: forty Act, it's finely greenlit and ready for launch. Everybody
Speaker 1: was excited. It was a big deal. They handed out hats,
Speaker 1: they had, you know, paraphernalia, A big giant spider hanging
Speaker 1: down from look like a Halloween dance. I heard on
Speaker 1: the floor of the exchange and the first day had
Speaker 1: traded a million shares. It was a big hit, seemingly.
Speaker 1: That's a lot, especially back then, and I think people
Speaker 1: were kind of intrigued. Moriarty says they were hoping that
Speaker 1: Spy would get a billion dollars in assets. When we
Speaker 1: launched it on the on the stock exchange, on the AMEX,
Speaker 1: there were probably a hundred people there, you know, on
Speaker 1: the floor, and they were probably the only hundred people
Speaker 1: who knew what this product was. And so it really
Speaker 1: devolved onto a whole bunch of of traders when the
Speaker 1: humans the fright, when it looked like the movie, so
Speaker 1: then it it really was a bunch of brokers and
Speaker 1: traders who would go to individual broker dealers and say, hey,
Speaker 1: we have this new product. Here's what it does. So
Speaker 1: it was really a evangelical sell for quite a while
Speaker 1: because people didn't really know what it was. People, you know, spiders.
Speaker 1: I didn't know what that meant. Et F wasn't invented,
Speaker 1: Yeah that's right. The term E t F wasn't even
Speaker 1: invented yet. That would come a few years later. So
Speaker 1: they gave it the taker Spy and an expense ratio
Speaker 1: of point to exactly the same as the point to
Speaker 1: expense ratio of the Vanguard five index fund, which already
Speaker 1: had six point five billion in assets. Bob Tole says,
Speaker 1: it was priced to compete with that very Vanguard product.
Speaker 1: So if the sp five was twice any, right, they
Speaker 1: did twenty and so that there would be this price
Speaker 1: shift between the two companies. This expense ratio was integral
Speaker 1: in keeping costs low for the e t F and
Speaker 1: ultimately for its long term success in democratizing investing. Next
Speaker 1: time on Trying Presents, we'll learn about other products similar
Speaker 1: to spy and why they didn't see the same success.
Speaker 1: Who who really cares? I mean, I suppose in retrospect
Speaker 1: you can make a good, you know, thriller movie out
Speaker 1: of it, somebody running the briefcase across the tracks kind
Speaker 1: of thing. But but in the end, all of these
Speaker 1: things come down to execution. And I think that's actually
Speaker 1: been the story of ETS for twenty five years, is
Speaker 1: it's always down to execution. Thanks for listening to Trillions Presents.
Speaker 1: Until next time. You can find us on the Bloomberg Terminal,
Speaker 1: Bloomberg dot com, Apple podcasts, and where else you want
Speaker 1: to listen. Trillions Presents is produced by Jordan's Bell with
Speaker 1: production help from Magnus Rokson. Francesco Leviy is the head
Speaker 1: of Bloomberg Podcast. And if you're still wondering about the
Speaker 1: SEC approval process, I have a question because you've been
Speaker 1: approved many times and I'm wondering, does the SEC have
Speaker 1: a big rubber stamp that says forty Act and they
Speaker 1: like put it on the paper when you when you
Speaker 1: finally been approved.