The ETF Story 3: The Approval

got to think about it. You know, you had Magic Johnson was ruling the NBA, George Michael was like all over the radio. It was a whole different culture. Right by the time the SEC approved it, Nirvana would had you know, Grunge was hot, Michael Jordan was running the NBA, Basic Lee, the whole kind of culture had changed. That's how long they had to wait. So what took the SEC so long and what happened during all those years? Well, we're going to answer those questions by walking through the

legal steps needed to gain the SEC's approval. But first, let's review what's considered the heartbeat of Spider and every other et F the creation redemption process. Bob Tole is president of his own E T F consulting company, but in the nineties he was vice president at Morgan Stanley and he worked with Nate Most to apply this creation redemption concept to the new trading vehicle which would become SPY. Now.

I was from the commodity brillion trading background. I traded silver and gold and stuff at Fibro and Morgan Stanley. Nate traded commodities in the Pacific, rim leather and some other stuff. Right, so we understood how all of this worked together, he says. They were bringing the com of the world to the equities market. Yeah. If you look at a COMEX gold warrant as they called it, right, it represented a hundred ounces of gold. Right, that's the

same size as futures contract. If you stood for delivery of the futures contract, you would get this warrant where this warehouse receipt if you will, right, and you would get collection of a hundred ounces of gold bars and had specific purities of specific weight, and you would pay for it. Right. But it was packaged. You traded it as a futures until an essence of futures was coming to maturity. At maturity, if you held the futures contract,

you would get delivered the gold. So to apply the warehouse receipt concept to the basket trading idea to design Spider like this, you could have a specific group of stocks handed to a custodian in return for shares, and those shares could be broken up and sold on an exchange. Plus, it could to work inversely, you buy shares on in exchange and then hand them to the warehouse custodian and

get a basket of stocks backed. This idea would need to have a virtual warehouse, though, so they partnered with State Street as a trustee and custody agent. They had the idea nailed down, but they needed some extra help getting Spider ready for the SEC. This wasn't just a matter of figuring out how the value of commodities can be traced using an index. The process also included an overwhelmingly complex legal spiderweb. So they had a young lawyer,

Kathleen Moriarty on their team. She was the one who had to work with the SEC a lot and make sure they were comfortable with things and work out all the details. Remember her Spider Woman. Many years ago, I was asked to work on a project that at the time was called Spears, not Spider, and it wasn't called Spider because people were afraid that a lot of arachnophobes would be turned off, and not by the e t F,

but we ultimately called it Spider. Anyway, Moriarity helped structure Spider and submitted to the sec why do they need you at all? What is the NETF need a lawyer? Because e t f s are registered security is they're registered with the Security is an Exchange Commission, and anytime you register a security with the Securities Exchange Commission, you need a lawyer. And they also wanted me to help

structure the unit trust in a particular way. Most in Bloom wanted the products holdings to reflect changes each day to the index, but the lawyers told them that was technically managing a fund, which meant they'd have to file the product under the Investment Company Act of nineteen as a unit investment trust or u I T. Moriarty says there was some debate over whether a unit trust or mutual fund would be the best vehicle for their product,

and then somebody said what's the difference, because they're both regulated by the forty Act. And one of the differences is it's a lot cheaper to run a unit trust because it doesn't have a board. It's very limited. It can do very limited things, so it doesn't have a whole lot of restrictions because it can't hardly do anything to begin with. So somebody said, why should we pay for a board and all these fancy arrangements when we're not going to be doing any of these fancy arrangements.

Why don't we do a unit trust, which would be cheaper. And that's how it came about. So they decide in their vehicle and they have to get it ready for filing under the forty Act. One of the things that is interesting is that an e t F, because it trades every day on an exchange, it wasn't technically just the clean forty Act approval. It had to get what's called an exemption, and that ultimately was part of the

reason it probably got held up. That the forty Act is, by far of the federal securities laws the most prohibitive of things. It makes you conform with certain rules and requirements, which is not the case for regular common stock. So in that way, it's an investor protection and statute worries about harming investors and making sure that the things aren't done that will harm investors. But there's nothing that's completely safe, because everything could be absolutely perfect and all the stocks

could tank. And so when they're thinking of putting it out into this it's sort of like the SEC stamping and saying it's ready for Middle America. Deeming a product ready for Middle America would be a big leap of faith that not everyone at the SEC was ready to make with this new product. Yeah, you have to understand, this kind of a filing was like a like a meteor or a foreign object landing into the SEC. It

was like nothing they've ever experienced. Remember they were just a bit shattered by the seven crash, so they were probably a little hesitant to approve anything quickly. Howard Kramer, who worked at the SEC at the time, describes the mood towards the Spider proposal. There were, you know, the

are pockets of cautiousness, as with any proposal. I mean, remember this is thirty years ago, where when ETFs hadn't existed, people had basically stocks, mutual funds, and some people dabbled in money market funds and that was pretty much it so to to some folks, to some staffers, it was a you know, it was it was a product that they had to get their arms around. You know, how can you have a mutual fund that trades continuously. It's

not a mutual fund if it does that. And my thought was, well, it's that's right, but it's not trying to be a mutual fund. It's trying to be a new product, and that has aspects significant aspects of the

mutual fund, but it's different. You'll recall Cramer was on the team that wrote the language in the SEC report from which most in Bloom got the idea for Spider, and he says he and others in the division had to do a little convincing to those who were more cautious about the product than they were and to why we were at one not only enthusiastic about it, but felt that it really did not pose concerns and should be just gotten off the ground as quickly as we could.

And a big bonus with Spider was that its structure made for significant tax benefits. In the case of Spiders or other e T F s. Most of, if not everything, is done by exchange and kind. So when somebody says the index doesn't track anymore, we're changing the index. They don't sell those securities. They deliver them to the person who creates them, and in exchange they get the other kind, the new kind back. So there is no tax situation occurring at the trust level because there's an exemption for

in kind exchanges. And that was, by the way, an unintended consequence. Nobody nobody planned that. One day one of the tax people was looking at it and he said, hey, you know this, this is going to be a tax exempt exchange. This unintended consequence was another big win for SPY because no money exchanges hands when shares are created or redeemed, the product would not emit capital gains distributions

the way that mutual funds do. After years of designing the structure and tailoring it for SEC approval under the forty Act, it's finely greenlit and ready for launch. Everybody was excited. It was a big deal. They handed out hats, they had, you know, paraphernalia, A big giant spider hanging down from look like a Halloween dance. I heard on the floor of the exchange and the first day had traded a million shares. It was a big hit, seemingly. That's a lot, especially back then, and I think people

were kind of intrigued. Moriarty says they were hoping that Spy would get a billion dollars in assets. When we launched it on the on the stock exchange, on the AMEX, there were probably a hundred people there, you know, on the floor, and they were probably the only hundred people

who knew what this product was. And so it really devolved onto a whole bunch of of traders when the humans the fright, when it looked like the movie, so then it it really was a bunch of brokers and traders who would go to individual broker dealers and say, hey, we have this new product. Here's what it does. So it was really a evangelical sell for quite a while because people didn't really know what it was. People, you know, spiders. I didn't know what that meant. Et F wasn't invented,

Yeah that's right. The term E t F wasn't even invented yet. That would come a few years later. So they gave it the taker Spy and an expense ratio of point to exactly the same as the point to expense ratio of the Vanguard five index fund, which already had six point five billion in assets. Bob Tole says, it was priced to compete with that very Vanguard product. So if the sp five was twice any, right, they did twenty and so that there would be this price

shift between the two companies. This expense ratio was integral in keeping costs low for the e t F and ultimately for its long term success in democratizing investing. Next time on Trying Presents, we'll learn about other products similar to spy and why they didn't see the same success. Who who really cares? I mean, I suppose in retrospect you can make a good, you know, thriller movie out of it, somebody running the briefcase across the tracks kind of thing. But but in the end, all of these

things come down to execution. And I think that's actually been the story of ETS for twenty five years, is it's always down to execution. Thanks for listening to Trillions Presents. Until next time. You can find us on the Bloomberg Terminal, Bloomberg dot com, Apple podcasts, and where else you want to listen. Trillions Presents is produced by Jordan's Bell with production help from Magnus Rokson. Francesco Leviy is the head

of Bloomberg Podcast. And if you're still wondering about the SEC approval process, I have a question because you've been approved many times and I'm wondering, does the SEC have a big rubber stamp that says forty Act and they like put it on the paper when you when you finally been approved.