WEBVTT - The Approval 0:00:06.200 --> 0:00:09.480 This is Trillions presents the h g F Story. I'm 0:00:09.560 --> 0:00:12.520 Joel Weber and I'm the editor of Bloomberg Business Week. 0:00:13.600 --> 0:00:16.280 In our last episode, we left off with Nathan Most 0:00:16.520 --> 0:00:20.000 and Stephen Bloom of Amex, who just conceived an idea 0:00:20.079 --> 0:00:23.320 for a new basket trading product that would track the 0:00:23.520 --> 0:00:27.440 S and P five hundred called Spider. The Amex submitted 0:00:27.440 --> 0:00:31.080 their product to the SEC in but I had to 0:00:31.120 --> 0:00:39.520 wait several years until January for approval. Here's Eric Baltunas, 0:00:39.880 --> 0:00:41.720 four years is still a long time. I mean, you've 0:00:41.720 --> 0:00:45.480 got to think about it. You know, you had Magic 0:00:45.560 --> 0:00:48.720 Johnson was ruling the NBA, George Michael was like all 0:00:48.760 --> 0:00:51.639 over the radio. It was a whole different culture. Right 0:00:52.840 --> 0:00:56.560 by the time the SEC approved it, Nirvana would had 0:00:56.640 --> 0:00:59.520 you know, Grunge was hot, Michael Jordan was running the NBA, 0:00:59.600 --> 0:01:02.800 Basic Lee, the whole kind of culture had changed. That's 0:01:02.800 --> 0:01:05.120 how long they had to wait. So what took the 0:01:05.280 --> 0:01:12.000 SEC so long and what happened during all those years? Well, 0:01:12.080 --> 0:01:14.440 we're going to answer those questions by walking through the 0:01:14.520 --> 0:01:18.839 legal steps needed to gain the SEC's approval. But first, 0:01:19.000 --> 0:01:22.160 let's review what's considered the heartbeat of Spider and every 0:01:22.200 --> 0:01:27.920 other et F the creation redemption process. Bob Tole is 0:01:28.000 --> 0:01:31.399 president of his own E T F consulting company, but 0:01:31.480 --> 0:01:35.280 in the nineties he was vice president at Morgan Stanley 0:01:35.319 --> 0:01:37.720 and he worked with Nate Most to apply this creation 0:01:37.800 --> 0:01:42.640 redemption concept to the new trading vehicle which would become SPY. Now. 0:01:42.720 --> 0:01:45.640 I was from the commodity brillion trading background. I traded 0:01:45.720 --> 0:01:50.000 silver and gold and stuff at Fibro and Morgan Stanley. 0:01:50.400 --> 0:01:54.520 Nate traded commodities in the Pacific, rim leather and some 0:01:54.640 --> 0:01:57.400 other stuff. Right, so we understood how all of this 0:01:57.480 --> 0:02:00.040 worked together, he says. They were bringing the commody of 0:02:00.120 --> 0:02:03.240 these world to the equities market. Yeah. If you look 0:02:03.320 --> 0:02:07.400 at a COMEX gold warrant as they called it, right, 0:02:07.880 --> 0:02:11.880 it represented a hundred ounces of gold, right, that's the 0:02:11.919 --> 0:02:15.960 same size as futures contract. If you stood for delivery 0:02:16.040 --> 0:02:19.919 of the futures contract, you would get this warrant where 0:02:19.960 --> 0:02:22.839 this warehouse receipt if you will, right, and you would 0:02:22.880 --> 0:02:25.400 get collection of a hundred ounces of gold bars and 0:02:25.440 --> 0:02:28.720 had specific purities of specific weight, and you would pay 0:02:28.800 --> 0:02:32.440 for it. Right. But it was packaged. You traded it 0:02:32.480 --> 0:02:35.160 as a futures until an essence of futures was coming 0:02:35.160 --> 0:02:38.079 to maturity. At maturity, if you held the futures contract, 0:02:38.280 --> 0:02:43.080 you would get delivered the gold. So to apply the 0:02:43.120 --> 0:02:47.480 warehouse receipt concept to the basket trading idea to design 0:02:47.560 --> 0:02:50.160 Spider like this, you could have a specific group of 0:02:50.160 --> 0:02:54.280 stocks handed to a custodian in return for shares, and 0:02:54.320 --> 0:02:59.440 those shares could be broken up and sold on an exchange. Plus, 0:02:59.680 --> 0:03:02.960 it could work conversely you buy shares on in exchange 0:03:03.360 --> 0:03:06.480 and then hand them to the warehouse custodian and get 0:03:06.480 --> 0:03:09.360 a basket of stocks backed. This idea would need to 0:03:09.360 --> 0:03:12.640 have a virtual warehouse, though, so they partnered with State 0:03:12.720 --> 0:03:16.480 Street as a trustee and custody agent. They had the 0:03:16.600 --> 0:03:20.000 idea nailed down, but they needed some extra help getting 0:03:20.040 --> 0:03:23.560 Spider ready for the SEC. This wasn't just a matter 0:03:23.600 --> 0:03:25.840 of figuring out how the value of commodities can be 0:03:25.880 --> 0:03:29.600 traced using an index. The process also included an overwhelmingly 0:03:29.680 --> 0:03:36.360 complex legal spiderweb. So they had a young lawyer, Kathleen 0:03:36.360 --> 0:03:39.600 Moriarty on their team. She was the one who had 0:03:39.640 --> 0:03:41.400 to work with the SEC a lot and make sure 0:03:41.440 --> 0:03:45.160 they were comfortable with things and work out all the details. Remember, 0:03:45.160 --> 0:03:48.760 her Spider Woman. Many years ago, I was asked to 0:03:48.760 --> 0:03:51.680 work on a project that at the time was called Spears, 0:03:51.680 --> 0:03:56.080 not Spider, and it wasn't called Spider because people were 0:03:56.120 --> 0:03:59.440 afraid that a lot of arachnophobes would be turned off 0:03:59.520 --> 0:04:01.600 and not one by the e t F, but we 0:04:01.720 --> 0:04:05.440 ultimately called it Spider. Anyway, Moriarity helped structure Spider and 0:04:05.520 --> 0:04:12.360 submitted to the sec why do they need you at all? 0:04:12.760 --> 0:04:15.760 Why is the NETF need a lawyer? Because e t 0:04:16.000 --> 0:04:18.400 F s are registered security is they're registered with the 0:04:18.440 --> 0:04:21.719 Security is an Exchange Commission, and anytime you register a 0:04:21.760 --> 0:04:24.560 security with the Securities Exchange Commission, you need a lawyer. 0:04:25.080 --> 0:04:27.680 And they also wanted me to help structure the unit 0:04:27.680 --> 0:04:31.919 trust in a particular way. Most in Bloom wanted the 0:04:31.920 --> 0:04:35.520 products holdings to reflect changes each day to the index, 0:04:36.120 --> 0:04:39.120 but the lawyers told them that was technically managing a fund, 0:04:39.640 --> 0:04:42.440 which meant they'd have to file the product under the 0:04:42.480 --> 0:04:46.840 Investment Company Act of nineteen as a unit investment trust 0:04:47.440 --> 0:04:52.160 or u I T. Moriarty says there was some debate 0:04:52.240 --> 0:04:55.400 over whether a unit trust or mutual fund would be 0:04:55.440 --> 0:05:00.680 the best vehicle for their product, and then somebody said, 0:05:00.720 --> 0:05:05.000 what's the difference, because they're both regulated by the forty Act. 0:05:05.440 --> 0:05:08.279 And one of the differences is it's a lot cheaper 0:05:08.320 --> 0:05:10.560 to run a unit trust because it doesn't have a board. 0:05:11.040 --> 0:05:14.320 It's very limited, it can do very limited things, so 0:05:14.360 --> 0:05:16.400 it doesn't have a whole lot of restrictions because it 0:05:16.400 --> 0:05:19.360 can't hardly do anything to begin with. So somebody said, 0:05:19.400 --> 0:05:21.719 why should we pay for a board and all these 0:05:21.720 --> 0:05:24.600 fancy arrangements when we're not going to be doing any 0:05:24.600 --> 0:05:27.320 of these fancy arrangements. Why don't we do a unit trust, 0:05:27.320 --> 0:05:29.480 which would be cheaper. And that's how it came about. 0:05:29.640 --> 0:05:31.680 So they decide on their vehicle and they have to 0:05:31.720 --> 0:05:36.560 get it ready for filing under the forty Act. One 0:05:36.560 --> 0:05:38.560 of the things that is interesting is that an e 0:05:38.680 --> 0:05:41.440 t F, because it trades every day on an exchange, 0:05:42.000 --> 0:05:46.279 it wasn't technically just the clean forty Act approval. It 0:05:46.400 --> 0:05:49.360 had to get what's called an exemption, and that ultimately 0:05:49.440 --> 0:05:51.480 was part of the reason it probably got held up 0:05:51.520 --> 0:05:53.520 that the forty Act is, by far of the federal 0:05:53.600 --> 0:05:57.560 securities laws the most prohibitive of things. It makes you 0:05:57.640 --> 0:06:00.760 conform with certain rules and requirements, which is not the 0:06:00.800 --> 0:06:04.400 case for regular common stock. So in that way, it's 0:06:04.400 --> 0:06:08.960 an investor protection and statute worries about harming investors and 0:06:09.040 --> 0:06:11.800 making sure that the things aren't done that will harm investors. 0:06:12.120 --> 0:06:16.120 But there's nothing that's completely safe, because everything could be 0:06:16.160 --> 0:06:20.240 absolutely perfect and all the stocks could tank. And so 0:06:20.240 --> 0:06:21.920 when they're thinking of putting it out into this it's 0:06:21.920 --> 0:06:24.080 sort of like the SEC stamping and saying it's ready 0:06:24.080 --> 0:06:28.160 for Middle America. Deeming a product ready for Middle America 0:06:28.240 --> 0:06:30.400 would be a big leap of faith that not everyone 0:06:30.520 --> 0:06:34.159 at the SEC was ready to make with this new product. Yeah, 0:06:34.160 --> 0:06:36.480 you have to understand, this kind of a filing was 0:06:36.560 --> 0:06:41.320 like a like a meteor or a foreign object landing 0:06:41.360 --> 0:06:43.960 into the SEC. It was like nothing they've ever experienced. Remember, 0:06:44.000 --> 0:06:47.480 they were just a bit shattered by the seven crash, 0:06:48.040 --> 0:06:51.720 so they were probably a little hesitant to approve anything quickly. 0:06:53.800 --> 0:06:56.160 Howard Kramer, who worked at the SEC at the time, 0:06:56.520 --> 0:06:59.760 describes the mood towards the Spider proposal. There were, you know, 0:06:59.839 --> 0:07:04.280 there are pockets of cautiousness, as with any proposal. I mean, 0:07:05.000 --> 0:07:10.080 remember this is thirty years ago, where when ETFs hadn't existed, 0:07:10.440 --> 0:07:15.200 people had basically stocks mutual funds, and some people dabbled 0:07:15.200 --> 0:07:16.960 in money market funds and that was pretty much it 0:07:17.560 --> 0:07:20.680 so to to some folks. To some staffers, it was 0:07:20.920 --> 0:07:24.360 a you know, it was it was a product that 0:07:25.400 --> 0:07:27.680 they had to get their arms around. You know, how 0:07:27.680 --> 0:07:30.240 can you have a mutual fund that trades continuously. It's 0:07:30.240 --> 0:07:33.000 not a mutual fund if it does that. And my 0:07:33.040 --> 0:07:36.560 thought was, well, it's that's right, but it's not trying 0:07:36.600 --> 0:07:39.000 to be a mutual fund. It's trying to be a 0:07:39.040 --> 0:07:43.800 new product, and that has aspects significant aspects of mutual fund, 0:07:43.840 --> 0:07:47.360 but it's different. You'll recall Cramer was on the team 0:07:47.440 --> 0:07:50.440 that wrote the language in the SEC report from which 0:07:50.520 --> 0:07:53.480 most in Bloom got the idea for Spider, and he 0:07:53.520 --> 0:07:55.920 says he and others in the division had to do 0:07:55.960 --> 0:07:58.520 a little convincing to those who were more cautious about 0:07:58.520 --> 0:08:00.800 the product than they were, and why we were at 0:08:00.840 --> 0:08:04.760 one not only enthusiastic about it, but felt that it 0:08:04.960 --> 0:08:09.640 really did not pose concerns and should be just gotten 0:08:09.680 --> 0:08:12.520 off the ground as quickly as we could. And a 0:08:12.560 --> 0:08:15.600 big bonus with Spider was that its structure made for 0:08:15.680 --> 0:08:19.120 significant tax benefits. In the case of Spiders or other 0:08:19.160 --> 0:08:22.600 e T F s. Most of, if not everything, is 0:08:22.640 --> 0:08:26.200 done by exchange and kind. So when somebody says the 0:08:26.240 --> 0:08:30.280 index doesn't track anymore, we're changing the index. They don't 0:08:30.320 --> 0:08:34.440 sell those securities. They deliver them to the person who 0:08:34.480 --> 0:08:38.440 creates them, and in exchange they get the other kind, 0:08:38.640 --> 0:08:42.040 the new kind back. So there is no tax situation 0:08:42.080 --> 0:08:45.560 occurring at the trust level because there's an exemption for 0:08:45.640 --> 0:08:48.200 in kind exchanges. And that was, by the way, an 0:08:48.280 --> 0:08:53.160 unintended consequence. Nobody nobody planned that. One day one of 0:08:53.200 --> 0:08:55.480 the tax people was looking at it and he said, hey, 0:08:55.520 --> 0:08:57.120 you know this, this is going to be a tax 0:08:57.120 --> 0:09:01.120 exempt exchange. This unintended consequence was another big win for 0:09:01.160 --> 0:09:05.520 SPY because no money exchanges hands when shares are created 0:09:05.720 --> 0:09:10.080 or redeemed, the product would not emit capital gains distributions 0:09:10.120 --> 0:09:15.080 the way that mutual funds do. After years of designing 0:09:15.080 --> 0:09:17.720 the structure and tailoring it for SEC approval under the 0:09:17.760 --> 0:09:23.480 forty Act, it's finely greenlit and ready for launch. Everybody 0:09:23.520 --> 0:09:27.440 was excited. It was a big deal. They handed out hats, 0:09:27.520 --> 0:09:31.360 they had, you know, paraphernalia, A big giant spider hanging 0:09:31.400 --> 0:09:34.120 down from look like a Halloween dance. I heard on 0:09:34.160 --> 0:09:36.880 the floor of the exchange and the first day had 0:09:36.880 --> 0:09:39.760 traded a million shares. It was a big hit, seemingly. 0:09:40.240 --> 0:09:44.080 That's a lot, especially back then, and I think people 0:09:44.360 --> 0:09:47.280 were kind of intrigued. Moriarty says they were hoping that 0:09:47.360 --> 0:09:50.160 Spy would get a billion dollars in assets. When we 0:09:50.240 --> 0:09:52.920 launched it on the on the stock exchange, on the AMEX, 0:09:53.120 --> 0:09:55.320 there were probably a hundred people there, you know, on 0:09:55.360 --> 0:09:57.760 the floor, and they were probably the only hundred people 0:09:57.760 --> 0:10:01.640 who knew what this product was. And so it really 0:10:01.720 --> 0:10:06.960 devolved onto a whole bunch of traders when the human 0:10:07.200 --> 0:10:09.160 fight when it looked like the movie, so then it 0:10:09.600 --> 0:10:12.960 it really was a bunch of brokers and traders who 0:10:13.080 --> 0:10:17.360 would go to individual broker dealers and say, hey, we 0:10:17.400 --> 0:10:20.160 have this new product. Here's what it does. So it 0:10:20.240 --> 0:10:24.920 was really a evangelical sell for quite a while because 0:10:24.960 --> 0:10:27.640 people didn't really know what it was. People, you know, spiders. 0:10:27.640 --> 0:10:30.360 I didn't know what that meant. Et F wasn't invented, 0:10:31.400 --> 0:10:34.400 Yeah that's right. The term E t F wasn't even 0:10:34.440 --> 0:10:37.280 invented yet. That would come a few years later. So 0:10:37.320 --> 0:10:40.240 they gave it the taker Spy and an expense ratio 0:10:40.360 --> 0:10:43.839 of point to exactly the same as the point to 0:10:44.720 --> 0:10:49.080 expense ratio of the Vanguard five Index five, which already 0:10:49.080 --> 0:10:54.520 had six point five billion in assets. Bob Tole says, 0:10:54.559 --> 0:10:57.319 it was priced to compete with that very Vanguard product. 0:10:57.559 --> 0:11:02.040 So if the sp five was twice me, right, they 0:11:02.200 --> 0:11:04.839 did twenty and so that there would be this price 0:11:04.880 --> 0:11:08.840 shift between the two companies. This expense ratio was integral 0:11:09.160 --> 0:11:11.679 in keeping costs low for the E t F and 0:11:11.800 --> 0:11:16.560 ultimately for its long term success in democratizing investing. Next 0:11:16.559 --> 0:11:19.600 time on trans Presents, we'll learn about other products similar 0:11:19.640 --> 0:11:22.440 to spy and why they didn't see the same success. 0:11:22.640 --> 0:11:25.000 Who who really cares? I mean, I suppose in retrospect 0:11:25.000 --> 0:11:27.520 you can make a good, you know, thriller movie out 0:11:27.520 --> 0:11:30.120 of it, somebody running the briefcase across the tracks kind 0:11:30.120 --> 0:11:33.400 of thing. But but in the end, all of these 0:11:33.400 --> 0:11:36.079 things come down to execution. And I think that's actually 0:11:36.080 --> 0:11:38.800 been the story of ETS for twenty five years, is 0:11:38.840 --> 0:11:49.720 it's always down to execution. Thanks for listening to Trillions Presents. 0:11:50.200 --> 0:11:52.720 Until next time. You can find us on the Bloomberg Terminal, 0:11:52.880 --> 0:11:56.240 Bloomberg dot com, Apple Podcasts, and where else you want 0:11:56.240 --> 0:12:00.280 to listen. Trillions Presents is produced by Jordan's Bell with 0:12:00.400 --> 0:12:04.200 production help from Magnus Hrokson. Francesco Levy is the head 0:12:04.240 --> 0:12:09.280 of Bloomberg Podcasts. And if you're still wondering about the 0:12:09.480 --> 0:12:12.760 SEC approval process, I have a question because you've been 0:12:12.800 --> 0:12:15.400 approved many times and I'm wondering, does the SEC have 0:12:15.520 --> 0:12:18.920 a big rubber stamp that says forty Act and they 0:12:19.000 --> 0:12:20.439 like put it on the paper when you when you 0:12:20.520 --> 0:12:21.360 finally been approved.