1 00:00:06,200 --> 00:00:09,480 Speaker 1: This is Trillions presents the h g F Story. I'm 2 00:00:09,560 --> 00:00:12,520 Speaker 1: Joel Weber and I'm the editor of Bloomberg Business Week. 3 00:00:13,600 --> 00:00:16,280 Speaker 1: In our last episode, we left off with Nathan Most 4 00:00:16,520 --> 00:00:20,000 Speaker 1: and Stephen Bloom of Amex, who just conceived an idea 5 00:00:20,079 --> 00:00:23,320 Speaker 1: for a new basket trading product that would track the 6 00:00:23,520 --> 00:00:27,440 Speaker 1: S and P five hundred called Spider. The Amex submitted 7 00:00:27,440 --> 00:00:31,080 Speaker 1: their product to the SEC in but I had to 8 00:00:31,120 --> 00:00:39,520 Speaker 1: wait several years until January for approval. Here's Eric Baltunas, 9 00:00:39,880 --> 00:00:41,720 Speaker 1: four years is still a long time. I mean, you've 10 00:00:41,720 --> 00:00:45,480 Speaker 1: got to think about it. You know, you had Magic 11 00:00:45,560 --> 00:00:48,720 Speaker 1: Johnson was ruling the NBA, George Michael was like all 12 00:00:48,760 --> 00:00:51,639 Speaker 1: over the radio. It was a whole different culture. Right 13 00:00:52,840 --> 00:00:56,560 Speaker 1: by the time the SEC approved it, Nirvana would had 14 00:00:56,640 --> 00:00:59,520 Speaker 1: you know, Grunge was hot, Michael Jordan was running the NBA, 15 00:00:59,600 --> 00:01:02,800 Speaker 1: Basic Lee, the whole kind of culture had changed. That's 16 00:01:02,800 --> 00:01:05,120 Speaker 1: how long they had to wait. So what took the 17 00:01:05,280 --> 00:01:12,000 Speaker 1: SEC so long and what happened during all those years? Well, 18 00:01:12,080 --> 00:01:14,440 Speaker 1: we're going to answer those questions by walking through the 19 00:01:14,520 --> 00:01:18,839 Speaker 1: legal steps needed to gain the SEC's approval. But first, 20 00:01:19,000 --> 00:01:22,160 Speaker 1: let's review what's considered the heartbeat of Spider and every 21 00:01:22,200 --> 00:01:27,920 Speaker 1: other et F the creation redemption process. Bob Tole is 22 00:01:28,000 --> 00:01:31,399 Speaker 1: president of his own E T F consulting company, but 23 00:01:31,480 --> 00:01:35,280 Speaker 1: in the nineties he was vice president at Morgan Stanley 24 00:01:35,319 --> 00:01:37,720 Speaker 1: and he worked with Nate Most to apply this creation 25 00:01:37,800 --> 00:01:42,640 Speaker 1: redemption concept to the new trading vehicle which would become SPY. Now. 26 00:01:42,720 --> 00:01:45,640 Speaker 1: I was from the commodity brillion trading background. I traded 27 00:01:45,720 --> 00:01:50,000 Speaker 1: silver and gold and stuff at Fibro and Morgan Stanley. 28 00:01:50,400 --> 00:01:54,520 Speaker 1: Nate traded commodities in the Pacific, rim leather and some 29 00:01:54,640 --> 00:01:57,400 Speaker 1: other stuff. Right, so we understood how all of this 30 00:01:57,480 --> 00:02:00,040 Speaker 1: worked together, he says. They were bringing the commody of 31 00:02:00,120 --> 00:02:03,240 Speaker 1: these world to the equities market. Yeah. If you look 32 00:02:03,320 --> 00:02:07,400 Speaker 1: at a COMEX gold warrant as they called it, right, 33 00:02:07,880 --> 00:02:11,880 Speaker 1: it represented a hundred ounces of gold, right, that's the 34 00:02:11,919 --> 00:02:15,960 Speaker 1: same size as futures contract. If you stood for delivery 35 00:02:16,040 --> 00:02:19,919 Speaker 1: of the futures contract, you would get this warrant where 36 00:02:19,960 --> 00:02:22,839 Speaker 1: this warehouse receipt if you will, right, and you would 37 00:02:22,880 --> 00:02:25,400 Speaker 1: get collection of a hundred ounces of gold bars and 38 00:02:25,440 --> 00:02:28,720 Speaker 1: had specific purities of specific weight, and you would pay 39 00:02:28,800 --> 00:02:32,440 Speaker 1: for it. Right. But it was packaged. You traded it 40 00:02:32,480 --> 00:02:35,160 Speaker 1: as a futures until an essence of futures was coming 41 00:02:35,160 --> 00:02:38,079 Speaker 1: to maturity. At maturity, if you held the futures contract, 42 00:02:38,280 --> 00:02:43,080 Speaker 1: you would get delivered the gold. So to apply the 43 00:02:43,120 --> 00:02:47,480 Speaker 1: warehouse receipt concept to the basket trading idea to design 44 00:02:47,560 --> 00:02:50,160 Speaker 1: Spider like this, you could have a specific group of 45 00:02:50,160 --> 00:02:54,280 Speaker 1: stocks handed to a custodian in return for shares, and 46 00:02:54,320 --> 00:02:59,440 Speaker 1: those shares could be broken up and sold on an exchange. Plus, 47 00:02:59,680 --> 00:03:02,960 Speaker 1: it could work conversely you buy shares on in exchange 48 00:03:03,360 --> 00:03:06,480 Speaker 1: and then hand them to the warehouse custodian and get 49 00:03:06,480 --> 00:03:09,360 Speaker 1: a basket of stocks backed. This idea would need to 50 00:03:09,360 --> 00:03:12,640 Speaker 1: have a virtual warehouse, though, so they partnered with State 51 00:03:12,720 --> 00:03:16,480 Speaker 1: Street as a trustee and custody agent. They had the 52 00:03:16,600 --> 00:03:20,000 Speaker 1: idea nailed down, but they needed some extra help getting 53 00:03:20,040 --> 00:03:23,560 Speaker 1: Spider ready for the SEC. This wasn't just a matter 54 00:03:23,600 --> 00:03:25,840 Speaker 1: of figuring out how the value of commodities can be 55 00:03:25,880 --> 00:03:29,600 Speaker 1: traced using an index. The process also included an overwhelmingly 56 00:03:29,680 --> 00:03:36,360 Speaker 1: complex legal spiderweb. So they had a young lawyer, Kathleen 57 00:03:36,360 --> 00:03:39,600 Speaker 1: Moriarty on their team. She was the one who had 58 00:03:39,640 --> 00:03:41,400 Speaker 1: to work with the SEC a lot and make sure 59 00:03:41,440 --> 00:03:45,160 Speaker 1: they were comfortable with things and work out all the details. Remember, 60 00:03:45,160 --> 00:03:48,760 Speaker 1: her Spider Woman. Many years ago, I was asked to 61 00:03:48,760 --> 00:03:51,680 Speaker 1: work on a project that at the time was called Spears, 62 00:03:51,680 --> 00:03:56,080 Speaker 1: not Spider, and it wasn't called Spider because people were 63 00:03:56,120 --> 00:03:59,440 Speaker 1: afraid that a lot of arachnophobes would be turned off 64 00:03:59,520 --> 00:04:01,600 Speaker 1: and not one by the e t F, but we 65 00:04:01,720 --> 00:04:05,440 Speaker 1: ultimately called it Spider. Anyway, Moriarity helped structure Spider and 66 00:04:05,520 --> 00:04:12,360 Speaker 1: submitted to the sec why do they need you at all? 67 00:04:12,760 --> 00:04:15,760 Speaker 1: Why is the NETF need a lawyer? Because e t 68 00:04:16,000 --> 00:04:18,400 Speaker 1: F s are registered security is they're registered with the 69 00:04:18,440 --> 00:04:21,719 Speaker 1: Security is an Exchange Commission, and anytime you register a 70 00:04:21,760 --> 00:04:24,560 Speaker 1: security with the Securities Exchange Commission, you need a lawyer. 71 00:04:25,080 --> 00:04:27,680 Speaker 1: And they also wanted me to help structure the unit 72 00:04:27,680 --> 00:04:31,919 Speaker 1: trust in a particular way. Most in Bloom wanted the 73 00:04:31,920 --> 00:04:35,520 Speaker 1: products holdings to reflect changes each day to the index, 74 00:04:36,120 --> 00:04:39,120 Speaker 1: but the lawyers told them that was technically managing a fund, 75 00:04:39,640 --> 00:04:42,440 Speaker 1: which meant they'd have to file the product under the 76 00:04:42,480 --> 00:04:46,840 Speaker 1: Investment Company Act of nineteen as a unit investment trust 77 00:04:47,440 --> 00:04:52,160 Speaker 1: or u I T. Moriarty says there was some debate 78 00:04:52,240 --> 00:04:55,400 Speaker 1: over whether a unit trust or mutual fund would be 79 00:04:55,440 --> 00:05:00,680 Speaker 1: the best vehicle for their product, and then somebody said, 80 00:05:00,720 --> 00:05:05,000 Speaker 1: what's the difference, because they're both regulated by the forty Act. 81 00:05:05,440 --> 00:05:08,279 Speaker 1: And one of the differences is it's a lot cheaper 82 00:05:08,320 --> 00:05:10,560 Speaker 1: to run a unit trust because it doesn't have a board. 83 00:05:11,040 --> 00:05:14,320 Speaker 1: It's very limited, it can do very limited things, so 84 00:05:14,360 --> 00:05:16,400 Speaker 1: it doesn't have a whole lot of restrictions because it 85 00:05:16,400 --> 00:05:19,360 Speaker 1: can't hardly do anything to begin with. So somebody said, 86 00:05:19,400 --> 00:05:21,719 Speaker 1: why should we pay for a board and all these 87 00:05:21,720 --> 00:05:24,600 Speaker 1: fancy arrangements when we're not going to be doing any 88 00:05:24,600 --> 00:05:27,320 Speaker 1: of these fancy arrangements. Why don't we do a unit trust, 89 00:05:27,320 --> 00:05:29,480 Speaker 1: which would be cheaper. And that's how it came about. 90 00:05:29,640 --> 00:05:31,680 Speaker 1: So they decide on their vehicle and they have to 91 00:05:31,720 --> 00:05:36,560 Speaker 1: get it ready for filing under the forty Act. One 92 00:05:36,560 --> 00:05:38,560 Speaker 1: of the things that is interesting is that an e 93 00:05:38,680 --> 00:05:41,440 Speaker 1: t F, because it trades every day on an exchange, 94 00:05:42,000 --> 00:05:46,279 Speaker 1: it wasn't technically just the clean forty Act approval. It 95 00:05:46,400 --> 00:05:49,360 Speaker 1: had to get what's called an exemption, and that ultimately 96 00:05:49,440 --> 00:05:51,480 Speaker 1: was part of the reason it probably got held up 97 00:05:51,520 --> 00:05:53,520 Speaker 1: that the forty Act is, by far of the federal 98 00:05:53,600 --> 00:05:57,560 Speaker 1: securities laws the most prohibitive of things. It makes you 99 00:05:57,640 --> 00:06:00,760 Speaker 1: conform with certain rules and requirements, which is not the 100 00:06:00,800 --> 00:06:04,400 Speaker 1: case for regular common stock. So in that way, it's 101 00:06:04,400 --> 00:06:08,960 Speaker 1: an investor protection and statute worries about harming investors and 102 00:06:09,040 --> 00:06:11,800 Speaker 1: making sure that the things aren't done that will harm investors. 103 00:06:12,120 --> 00:06:16,120 Speaker 1: But there's nothing that's completely safe, because everything could be 104 00:06:16,160 --> 00:06:20,240 Speaker 1: absolutely perfect and all the stocks could tank. And so 105 00:06:20,240 --> 00:06:21,920 Speaker 1: when they're thinking of putting it out into this it's 106 00:06:21,920 --> 00:06:24,080 Speaker 1: sort of like the SEC stamping and saying it's ready 107 00:06:24,080 --> 00:06:28,160 Speaker 1: for Middle America. Deeming a product ready for Middle America 108 00:06:28,240 --> 00:06:30,400 Speaker 1: would be a big leap of faith that not everyone 109 00:06:30,520 --> 00:06:34,159 Speaker 1: at the SEC was ready to make with this new product. Yeah, 110 00:06:34,160 --> 00:06:36,480 Speaker 1: you have to understand, this kind of a filing was 111 00:06:36,560 --> 00:06:41,320 Speaker 1: like a like a meteor or a foreign object landing 112 00:06:41,360 --> 00:06:43,960 Speaker 1: into the SEC. It was like nothing they've ever experienced. Remember, 113 00:06:44,000 --> 00:06:47,480 Speaker 1: they were just a bit shattered by the seven crash, 114 00:06:48,040 --> 00:06:51,720 Speaker 1: so they were probably a little hesitant to approve anything quickly. 115 00:06:53,800 --> 00:06:56,160 Speaker 1: Howard Kramer, who worked at the SEC at the time, 116 00:06:56,520 --> 00:06:59,760 Speaker 1: describes the mood towards the Spider proposal. There were, you know, 117 00:06:59,839 --> 00:07:04,280 Speaker 1: there are pockets of cautiousness, as with any proposal. I mean, 118 00:07:05,000 --> 00:07:10,080 Speaker 1: remember this is thirty years ago, where when ETFs hadn't existed, 119 00:07:10,440 --> 00:07:15,200 Speaker 1: people had basically stocks mutual funds, and some people dabbled 120 00:07:15,200 --> 00:07:16,960 Speaker 1: in money market funds and that was pretty much it 121 00:07:17,560 --> 00:07:20,680 Speaker 1: so to to some folks. To some staffers, it was 122 00:07:20,920 --> 00:07:24,360 Speaker 1: a you know, it was it was a product that 123 00:07:25,400 --> 00:07:27,680 Speaker 1: they had to get their arms around. You know, how 124 00:07:27,680 --> 00:07:30,240 Speaker 1: can you have a mutual fund that trades continuously. It's 125 00:07:30,240 --> 00:07:33,000 Speaker 1: not a mutual fund if it does that. And my 126 00:07:33,040 --> 00:07:36,560 Speaker 1: thought was, well, it's that's right, but it's not trying 127 00:07:36,600 --> 00:07:39,000 Speaker 1: to be a mutual fund. It's trying to be a 128 00:07:39,040 --> 00:07:43,800 Speaker 1: new product, and that has aspects significant aspects of mutual fund, 129 00:07:43,840 --> 00:07:47,360 Speaker 1: but it's different. You'll recall Cramer was on the team 130 00:07:47,440 --> 00:07:50,440 Speaker 1: that wrote the language in the SEC report from which 131 00:07:50,520 --> 00:07:53,480 Speaker 1: most in Bloom got the idea for Spider, and he 132 00:07:53,520 --> 00:07:55,920 Speaker 1: says he and others in the division had to do 133 00:07:55,960 --> 00:07:58,520 Speaker 1: a little convincing to those who were more cautious about 134 00:07:58,520 --> 00:08:00,800 Speaker 1: the product than they were, and why we were at 135 00:08:00,840 --> 00:08:04,760 Speaker 1: one not only enthusiastic about it, but felt that it 136 00:08:04,960 --> 00:08:09,640 Speaker 1: really did not pose concerns and should be just gotten 137 00:08:09,680 --> 00:08:12,520 Speaker 1: off the ground as quickly as we could. And a 138 00:08:12,560 --> 00:08:15,600 Speaker 1: big bonus with Spider was that its structure made for 139 00:08:15,680 --> 00:08:19,120 Speaker 1: significant tax benefits. In the case of Spiders or other 140 00:08:19,160 --> 00:08:22,600 Speaker 1: e T F s. Most of, if not everything, is 141 00:08:22,640 --> 00:08:26,200 Speaker 1: done by exchange and kind. So when somebody says the 142 00:08:26,240 --> 00:08:30,280 Speaker 1: index doesn't track anymore, we're changing the index. They don't 143 00:08:30,320 --> 00:08:34,440 Speaker 1: sell those securities. They deliver them to the person who 144 00:08:34,480 --> 00:08:38,440 Speaker 1: creates them, and in exchange they get the other kind, 145 00:08:38,640 --> 00:08:42,040 Speaker 1: the new kind back. So there is no tax situation 146 00:08:42,080 --> 00:08:45,560 Speaker 1: occurring at the trust level because there's an exemption for 147 00:08:45,640 --> 00:08:48,200 Speaker 1: in kind exchanges. And that was, by the way, an 148 00:08:48,280 --> 00:08:53,160 Speaker 1: unintended consequence. Nobody nobody planned that. One day one of 149 00:08:53,200 --> 00:08:55,480 Speaker 1: the tax people was looking at it and he said, hey, 150 00:08:55,520 --> 00:08:57,120 Speaker 1: you know this, this is going to be a tax 151 00:08:57,120 --> 00:09:01,120 Speaker 1: exempt exchange. This unintended consequence was another big win for 152 00:09:01,160 --> 00:09:05,520 Speaker 1: SPY because no money exchanges hands when shares are created 153 00:09:05,720 --> 00:09:10,080 Speaker 1: or redeemed, the product would not emit capital gains distributions 154 00:09:10,120 --> 00:09:15,080 Speaker 1: the way that mutual funds do. After years of designing 155 00:09:15,080 --> 00:09:17,720 Speaker 1: the structure and tailoring it for SEC approval under the 156 00:09:17,760 --> 00:09:23,480 Speaker 1: forty Act, it's finely greenlit and ready for launch. Everybody 157 00:09:23,520 --> 00:09:27,440 Speaker 1: was excited. It was a big deal. They handed out hats, 158 00:09:27,520 --> 00:09:31,360 Speaker 1: they had, you know, paraphernalia, A big giant spider hanging 159 00:09:31,400 --> 00:09:34,120 Speaker 1: down from look like a Halloween dance. I heard on 160 00:09:34,160 --> 00:09:36,880 Speaker 1: the floor of the exchange and the first day had 161 00:09:36,880 --> 00:09:39,760 Speaker 1: traded a million shares. It was a big hit, seemingly. 162 00:09:40,240 --> 00:09:44,080 Speaker 1: That's a lot, especially back then, and I think people 163 00:09:44,360 --> 00:09:47,280 Speaker 1: were kind of intrigued. Moriarty says they were hoping that 164 00:09:47,360 --> 00:09:50,160 Speaker 1: Spy would get a billion dollars in assets. When we 165 00:09:50,240 --> 00:09:52,920 Speaker 1: launched it on the on the stock exchange, on the AMEX, 166 00:09:53,120 --> 00:09:55,320 Speaker 1: there were probably a hundred people there, you know, on 167 00:09:55,360 --> 00:09:57,760 Speaker 1: the floor, and they were probably the only hundred people 168 00:09:57,760 --> 00:10:01,640 Speaker 1: who knew what this product was. And so it really 169 00:10:01,720 --> 00:10:06,960 Speaker 1: devolved onto a whole bunch of traders when the human 170 00:10:07,200 --> 00:10:09,160 Speaker 1: fight when it looked like the movie, so then it 171 00:10:09,600 --> 00:10:12,960 Speaker 1: it really was a bunch of brokers and traders who 172 00:10:13,080 --> 00:10:17,360 Speaker 1: would go to individual broker dealers and say, hey, we 173 00:10:17,400 --> 00:10:20,160 Speaker 1: have this new product. Here's what it does. So it 174 00:10:20,240 --> 00:10:24,920 Speaker 1: was really a evangelical sell for quite a while because 175 00:10:24,960 --> 00:10:27,640 Speaker 1: people didn't really know what it was. People, you know, spiders. 176 00:10:27,640 --> 00:10:30,360 Speaker 1: I didn't know what that meant. Et F wasn't invented, 177 00:10:31,400 --> 00:10:34,400 Speaker 1: Yeah that's right. The term E t F wasn't even 178 00:10:34,440 --> 00:10:37,280 Speaker 1: invented yet. That would come a few years later. So 179 00:10:37,320 --> 00:10:40,240 Speaker 1: they gave it the taker Spy and an expense ratio 180 00:10:40,360 --> 00:10:43,839 Speaker 1: of point to exactly the same as the point to 181 00:10:44,720 --> 00:10:49,080 Speaker 1: expense ratio of the Vanguard five Index five, which already 182 00:10:49,080 --> 00:10:54,520 Speaker 1: had six point five billion in assets. Bob Tole says, 183 00:10:54,559 --> 00:10:57,319 Speaker 1: it was priced to compete with that very Vanguard product. 184 00:10:57,559 --> 00:11:02,040 Speaker 1: So if the sp five was twice me, right, they 185 00:11:02,200 --> 00:11:04,839 Speaker 1: did twenty and so that there would be this price 186 00:11:04,880 --> 00:11:08,840 Speaker 1: shift between the two companies. This expense ratio was integral 187 00:11:09,160 --> 00:11:11,679 Speaker 1: in keeping costs low for the E t F and 188 00:11:11,800 --> 00:11:16,560 Speaker 1: ultimately for its long term success in democratizing investing. Next 189 00:11:16,559 --> 00:11:19,600 Speaker 1: time on trans Presents, we'll learn about other products similar 190 00:11:19,640 --> 00:11:22,440 Speaker 1: to spy and why they didn't see the same success. 191 00:11:22,640 --> 00:11:25,000 Speaker 1: Who who really cares? I mean, I suppose in retrospect 192 00:11:25,000 --> 00:11:27,520 Speaker 1: you can make a good, you know, thriller movie out 193 00:11:27,520 --> 00:11:30,120 Speaker 1: of it, somebody running the briefcase across the tracks kind 194 00:11:30,120 --> 00:11:33,400 Speaker 1: of thing. But but in the end, all of these 195 00:11:33,400 --> 00:11:36,079 Speaker 1: things come down to execution. And I think that's actually 196 00:11:36,080 --> 00:11:38,800 Speaker 1: been the story of ETS for twenty five years, is 197 00:11:38,840 --> 00:11:49,720 Speaker 1: it's always down to execution. Thanks for listening to Trillions Presents. 198 00:11:50,200 --> 00:11:52,720 Speaker 1: Until next time. You can find us on the Bloomberg Terminal, 199 00:11:52,880 --> 00:11:56,240 Speaker 1: Bloomberg dot com, Apple Podcasts, and where else you want 200 00:11:56,240 --> 00:12:00,280 Speaker 1: to listen. Trillions Presents is produced by Jordan's Bell with 201 00:12:00,400 --> 00:12:04,200 Speaker 1: production help from Magnus Hrokson. Francesco Levy is the head 202 00:12:04,240 --> 00:12:09,280 Speaker 1: of Bloomberg Podcasts. And if you're still wondering about the 203 00:12:09,480 --> 00:12:12,760 Speaker 1: SEC approval process, I have a question because you've been 204 00:12:12,800 --> 00:12:15,400 Speaker 1: approved many times and I'm wondering, does the SEC have 205 00:12:15,520 --> 00:12:18,920 Speaker 1: a big rubber stamp that says forty Act and they 206 00:12:19,000 --> 00:12:20,439 Speaker 1: like put it on the paper when you when you 207 00:12:20,520 --> 00:12:21,360 Speaker 1: finally been approved.