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 commody of
Speaker 1: these 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 work conversely you buy shares on in exchange
Speaker 1: and then hand them to the warehouse custodian and get
Speaker 1: a basket of stocks backed. This idea would need to
Speaker 1: have a virtual warehouse, though, so they partnered with State
Speaker 1: Street as a trustee and custody agent. They had the
Speaker 1: idea nailed down, but they needed some extra help getting
Speaker 1: Spider ready for the SEC. This wasn't just a matter
Speaker 1: of figuring out how the value of commodities can be
Speaker 1: traced using an index. The process also included an overwhelmingly
Speaker 1: complex legal spiderweb. So they had a young lawyer, Kathleen
Speaker 1: Moriarty on their team. She was the one who had
Speaker 1: to work with the SEC a lot and make sure
Speaker 1: they were comfortable with things and work out all the details. Remember,
Speaker 1: her Spider Woman. Many years ago, I was asked to
Speaker 1: work on a project that at the time was called Spears,
Speaker 1: not Spider, and it wasn't called Spider because people were
Speaker 1: afraid that a lot of arachnophobes would be turned off
Speaker 1: and not one by the e t F, but we
Speaker 1: ultimately called it Spider. Anyway, Moriarity helped structure Spider and
Speaker 1: submitted to the sec why do they need you at all?
Speaker 1: Why is the NETF need a lawyer? Because e t
Speaker 1: F s are registered security is they're registered with the
Speaker 1: Security is an Exchange Commission, and anytime you register a
Speaker 1: security with the Securities Exchange Commission, you need a lawyer.
Speaker 1: And they also wanted me to help structure the unit
Speaker 1: trust in a particular way. Most in Bloom wanted the
Speaker 1: products holdings to reflect changes each day to the index,
Speaker 1: but the lawyers told them that was technically managing a fund,
Speaker 1: which meant they'd have to file the product under the
Speaker 1: Investment Company Act of nineteen as a unit investment trust
Speaker 1: or u I T. Moriarty says there was some debate
Speaker 1: over whether a unit trust or mutual fund would be
Speaker 1: the best vehicle for their product, and then somebody said,
Speaker 1: what's the difference, because they're both regulated by the forty Act.
Speaker 1: And one of the differences is it's a lot cheaper
Speaker 1: to run a unit trust because it doesn't have a board.
Speaker 1: It's very limited, it can do very limited things, so
Speaker 1: it doesn't have a whole lot of restrictions because it
Speaker 1: can't hardly do anything to begin with. So somebody said,
Speaker 1: why should we pay for a board and all these
Speaker 1: fancy arrangements when we're not going to be doing any
Speaker 1: of these fancy arrangements. Why don't we do a unit trust,
Speaker 1: which would be cheaper. And that's how it came about.
Speaker 1: So they decide on their vehicle and they have to
Speaker 1: get it ready for filing under the forty Act. One
Speaker 1: of the things that is interesting is that an e
Speaker 1: t F, because it trades every day on an exchange,
Speaker 1: it wasn't technically just the clean forty Act approval. It
Speaker 1: had to get what's called an exemption, and that ultimately
Speaker 1: was part of the reason it probably got held up
Speaker 1: that the forty Act is, by far of the federal
Speaker 1: securities laws the most prohibitive of things. It makes you
Speaker 1: conform with certain rules and requirements, which is not the
Speaker 1: case for regular common stock. So in that way, it's
Speaker 1: an investor protection and statute worries about harming investors and
Speaker 1: making sure that the things aren't done that will harm investors.
Speaker 1: But there's nothing that's completely safe, because everything could be
Speaker 1: absolutely perfect and all the stocks could tank. And so
Speaker 1: when they're thinking of putting it out into this it's
Speaker 1: sort of like the SEC stamping and saying it's ready
Speaker 1: for Middle America. Deeming a product ready for Middle America
Speaker 1: would be a big leap of faith that not everyone
Speaker 1: at the SEC was ready to make with this new product. Yeah,
Speaker 1: you have to understand, this kind of a filing was
Speaker 1: like a like a meteor or a foreign object landing
Speaker 1: into the SEC. It was like nothing they've ever experienced. Remember,
Speaker 1: they were just a bit shattered by the seven crash,
Speaker 1: so they were probably a little hesitant to approve anything quickly.
Speaker 1: Howard Kramer, who worked at the SEC at the time,
Speaker 1: describes the mood towards the Spider proposal. There were, you know,
Speaker 1: there 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 mutual fund,
Speaker 1: but it's different. You'll recall Cramer was on the team
Speaker 1: that wrote the language in the SEC report from which
Speaker 1: most in Bloom got the idea for Spider, and he
Speaker 1: says he and others in the division had to do
Speaker 1: a little convincing to those who were more cautious about
Speaker 1: the product than they were, and why we were at
Speaker 1: one not only enthusiastic about it, but felt that it
Speaker 1: really did not pose concerns and should be just gotten
Speaker 1: off the ground as quickly as we could. And a
Speaker 1: big bonus with Spider was that its structure made for
Speaker 1: significant tax benefits. In the case of Spiders or other
Speaker 1: e T F s. Most of, if not everything, is
Speaker 1: done by exchange and kind. So when somebody says the
Speaker 1: index doesn't track anymore, we're changing the index. They don't
Speaker 1: sell those securities. They deliver them to the person who
Speaker 1: 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 traders when the human
Speaker 1: fight when it looked like the movie, so then it
Speaker 1: it really was a bunch of brokers and traders who
Speaker 1: would go to individual broker dealers and say, hey, we
Speaker 1: have this new product. Here's what it does. So it
Speaker 1: was really a evangelical sell for quite a while because
Speaker 1: 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 five, 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 me, 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 trans 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 Hrokson. Francesco Levy is the head
Speaker 1: of Bloomberg Podcasts. 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.