Editor’s Note:This interview is part of a “SPY@20” series of pieces IndexUniverse is rolling out to commemorate the 20 th anniversary of the first U.S.-listed ETF. The package will include a number of interviews with industry sources as well as blogs from IndexUniverse senior executives. The stories that have run so far include the following:
- SPY@20:First ETF Changed Investing
- SPY@20: S'P 500 ' Indexing, The Perfect Mix
- SPY@20:You’ve Come A Long Way Baby
Kathleen Moriarty, a partner at the New York-based law firm Katten Muchin Rosenman LLP, was there at the very beginning of the exchange-traded fund industry. Moriarty helped Nate Most draft the regulatory paperwork that would make his brainchild, the SPDR S'P 500 ETF (SPY), a reality.
Twenty years later, Moriarty wears with pride and a sense of humor the nickname “SPDR Woman” that she earned during that seminal experience. The fact that SPY now has nearly $130 billion in assets only adds to her sense of wonder about it all. But her surprise at its vast success and her gratitude about being part of history is also accompanied by a sense of optimism about what the future holds for the ETF world spawned by SPY.
IU: Let me look at my cheat sheet here and I’ll tell you, just in case you hadn’t thought about it lately, how much money is in SPY right now on its 20 th anniversary:$127 billion. So, what say you, Kathleen Moriarty?
Moriarty: I can tell you for a fact that when we launched it we were hoping to get $1 billion. We didn’t think that was ridiculous. Of course we hoped for more, but we thought $1 billion would be a realistic number in 1993.
IU: Why did you choose to ask for approval of this particular unit investment trust legal structure as opposed to the full open-end one like competing S'P 500 ETFs, say the iShares S'P Core ETF (IVV) or the Vanguard S'P 500 ETF (VOO), different funds that can reinvest dividends?
Moriarty: It was because it was conceived of for a completely different purpose. In other words, Nate did not have a securities background. He was a commodities person. And when he was thinking about this, he did talk to John Bogle about it, and Bogle said:“It will be a disaster because of all the intraday stuff and the way they manage your portfolios. It would just be a complete disaster. You would be selling in and out with horrible tax consequences.” So Nate went back to the drawing board.
Moriarty (cont'd.): So he didn’t go back to the concept of the mutual fund at all. He started thinking about commodities and, depending on the commodity, you immobilize a commodity in a warehouse and you don’t actually trade the stuff, you trade the receipts for the stuff. So what people do instead of trading bales of cotton is they trade certificates for bales of cotton, and they’re negotiable. So if I own a certificate for 100 bales of cotton and I want to sell it, you want to buy it, and I sell it to you and you buy it, and then the cotton is yours. And if you want to go in and get the cotton you can go and get the cotton. It’s your expense. You have to go pick it up, but those bales of cotton are yours. That’s what that certificate entitles you to.
So he thought, “Why not effectively immobilize the security?” because what he and institutions viewed the S'P 500 as was that they were trading a basket. They weren’t trading a mutual fund. Nobody wanted to personally manage anything. They wanted the 500 stocks, and then if they changed they wanted the changed basket of the 500; that’s all. They didn’t want any reinvestment. They didn’t want any board directors. They didn’t want any anything. They wanted to make it like cotton, except instead of cotton, it would be little boxes of the 500 stocks.
IU: Are you saying that it was not designed whatsoever as a buy-and-hold instrument?
Moriarty: No I wasn’t saying that, but Nate’s goal was to create a new product that would trade on the Amex. The most important thing was it had to trade, because the Amex had lost a lot of market share and it wanted to increase market share by having a new product that would be available there and that would trade heavily. That’s where the revenue would come from. So they weren’t interested in having a big management fee, and they weren’t interested in managing it, because that’s not where they were looking to get the money. They were looking to get the money from the trading.
So, that original perspective is really a commodities perspective. That was why it was always so interesting to me that a commodities person ended up inventing something that became a securities instrument.
IU:From a regulatory perspective, was the unit investment trust an easier thing to get through the SEC than an open-end fund?
Moriarty: Actually, it’s hard to say. Using an open-end fund as a basis is often easier than a unit trust, because the vast majority of funds in America are open-end funds, and so they have the most rules, they have the most history.
In a unit trust, we don’t have anything like that, so sometimes the SEC is less likely to grant exemptions to a unit trust, because they don’t, there was no “there” there. Now in this case, because we were doing something ultimately fairly simple in terms of the portfolio, the SEC agreed we didn’t need to have a board, and so it turned out not to be a problem for us, because nothing that we wanted to do really mattered whether we had a board or we didn’t have a board. So in our particular case, the commission was pretty much indifferent.
IU: You were looking for the simplest structure that could accommodate an unmanaged portfolio, and that was the unit investment trust.
Moriarty: Absolutely. And actually we thought about dividend reinvestment at the time and we didn’t put it in originally because, again, Nate said, “People who own the S'P 500 aren’t looking for dividend reinvestment necessarily. They’re looking at the basket, and if they keep it long enough to get dividends, that’s fine, but they may not, so that isn’t a critical structural feature.”
Then about six months after we launched, people started saying, “Why can’t we reinvest?”
IU: Reinvest dividends, you mean?
Moriarty: Right. So we adopted a dividend reinvestment plan. Now, we couldn’t adopt an internal reinvestment plan the way open-end funds do, because we weren’t permitted to do that since we were not a managed fund, and that is considered to be managing.
IU: So it’s inaccurate to say that you can’t reinvest dividends in SPY? It’s just the legal mechanism that affords that possibility that is different than in an open-end fund; is that what you’re saying?
Moriarty: Well that was the case, but then later—this is fairly recent—the SEC decided that SPDRs and SPDR Dow Jones Industrial Average Trust (DIA) and the SPDR S'P MidCap 400 ETF (MDY)couldn’t have a reinvestment program even though we did have one, so that had to be terminated.
But there is certainly no question that you can, if you’re adding your 401(k) or something and you get dividends, you can then ask your broker-dealer to reinvest those dividends in more shares that are purchased on the open market. You just can’t do it as efficiently as you can if it was its own dividend reinvestment plan.
IU: What sort of insights, apart from surprise, do you cull from this extraordinary experience of being part of a team that helped start what is now one the biggest portfolios in the world?
Moriarty: It comes back to Nate:He said “Let’s keep it simple.” He really wanted it to just do what it was supposed to do and not have a thousand bells and whistles that would make it look cooler or more interesting but maybe get in the way or maybe make things complicated or maybe cost more. His view was very much that people want to invest in these stocks, and they don’t want to pay a lot for it and they don’t want to do a lot with them. They either want to sell them or buy them or hold them. And let’s just stick to the vision of doing something as simple as we can.
IU: ETF assets are now at $1.417 trillion, near an all-time record—suffice it to say this juggernaut is still gathering steam. Is there anything about how this whole thing is unfolding that gives you pause, or are you pretty excited about the future?
Moriarty: I think I’m pretty much of the latter. But also I think—and I think this is true for securities in general, not just ETFs—as the various safety nets continue to be chiseled away and corporations continue to chisel away at defined benefit programs, individuals are going to be more and more responsible for their own retirement planning. And I think there is really going to have to be an incredible crank-up in investor education because people just have to know more than they know now to really invest properly.
IU: Is the ETF industry well suited to rise to that challenge?
Moriarty: I think the ETF industry is largely prepared to rise to that issue.
The one concern that I have is about the totally nontransparent active ETF. If the transparency goes away, I think there probably is some way you can figure out another mechanism that will make sure that the NAV is close to market price. But what people forget about the ETF was we would have never gotten that approval if we couldn’t have more or less convinced the commission that the ETF was going to sell its shares in the open market roughly at the same price as NAV. Without that assurance, the commission never would have adopted it, because the whole core of the ’40 Act is to permit everybody to get NAV.
IU:Do you get the feeling, having pretty deep experience working with the SEC, that it’s prepared to fully deal with all the traffic as it relates to ETFs? Are there any adjustments at the commission that relate to ETFs that you would like to see in place that relate to ETFs in particular?
Moriarty: The fact that recently the division of Investment Management has lifted the moratorium on the regular use of derivatives by ETFs is a good sign.
The commission is in a state of flux now anyway, so it’s hard to say. The active ETF is really a very big thing. I think it’s a bigger step than the transparent active ETF, for a number of reasons. And I think the commission is going to have to have a lot of time and a fair amount of energy and willpower to get that done if that’s what they want to do.
IU: And when you say “active” in this context, you’re talking about the disclosure of portfolio holdings four times a year with the lag period, as opposed to the disclosure every evening like the quasi-active ETFs that now are on the market?
Moriarty: Exactly. To me a real active ETF is like a mutual fund.
IU: Do you think that the truly active ETF will be welcomed from a regulatory perspective, or do you think that that is an open question?
Moriarty: I think it’s an open question.
IU: You keep circling back to Nate, and I realize he is truly the father of the SPY and of the ETF in the United States. But are there any other people that you think of as often?
Moriarty: You mean in terms of the ETF’s startup?
IU: Yes, at the genesis of the whole thing.
Moriarty: Oh yes. What I always like to tell people is that one of the most fun things about working on SPDRs was that there were a number of different institutions and they were all cooperating with each other. No one was paying anybody else’s way. Everybody chipped in pretty much, and everybody just did it for the product.
IU: So, the stars were aligning:State Street Global Advisors and people like Jim Ross, Nate at the Amex and so on? For an exquisite period of time, a lot of the internecine warfare of Wall Street was suspended.
IU: Why then? Why those parties?
Moriarty: Nate wanted to make sure that he got the right people, so when we did MidCap SPDRs, he used Bank of New York, because he wanted to use a different trustee to see how the competition would go. And then for the Diamonds, he went back to State Street. I believe he was inclined to use people like State Street and Bank of New York because he wanted very-well-known-institutional-long-term-money-custodian-manager-trust kind of people, so he didn’t want some strange little bank or whatever. He wanted really old-line kind of players.
IU: So what was the feel of it, overall?
Moriarty: This was pre-Internet, so we all had phone conversations, we had conference calls, and more importantly, we had face-to-face meetings all the time. It was very, very personal.
IU:So was that pre-Internet context laughably inefficient or super high-touch?
Moriarty: It was very efficient, because unlike the Internet, you didn’t have people remotely in different places half paying attention and shooting off emails before they knew what they were doing or agreeing to something before they had really read something. And they were all sitting in a room and they all had to focus, and you could tell immediately if somebody was not paying attention. And we would all arrive at a decision and because we were all there, and we would all sign off, so it was very, very efficient.
IU:So this worked in SPY’s favor?
Moriarty: Yes—you got to know people, you got to know how they think. You could see their reactions before they even spoke. It was very engaging, we met a lot and we knew really each other. It was a wonderful experience.
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