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News October 8, 2018 Issue

Asset Management Community Strongly Supports ETF Rule with Some Caveats

Associations representing investment companies and others in the asset management community have come out strongly in favor of the SEC’s proposed Exchange-Traded Funds (ETF) Rule. It’s rare that support is 100 percent, however – most of those supporting the proposal also had suggestions for changes or further improvements.

The ETF Rule – formally Rule 6c-11 under the Investment Company Act and accompanying form amendments – was proposed by the Commission on June 28. At its most basic, it would allow ETFs organized as open-end funds to operate without having to first secure a fund-specific agency exemption from the agency. After proposing the Rule, the SEC opened it up to the public for comments, with a deadline of October 1.

ETFs, investment products which, according to the agency, now account for over $3.6 trillion in assets, are hybrid products that were not originally envisioned in U.S. securities laws. Those funds share traits with both mutual funds, in that large institutions can seek redemptions directly from the funds, but also with traditional stocks and closed-end funds, in that they can be traded on public exchanges. There are currently more than 1,900 ETFs in existence, representing almost 15 percent of total investment company worth.

“The proposal would replace hundreds of individualized exemptive orders with a single rule subject to public notice and compliance,” said the SEC, which has issued more than 300 exemptive orders allowing ETFs to operate since 1992. “The standardized conditions are designed to level the playing field among most ETFs and protect ETF investors, while proposed disclosure amendments would provide investors who purchase and sell ETF shares on the secondary market with new information.”

In addition to the broad parameter of allowing ETFs to rely on the Investment Company Act to operate rather than seek individual exemptions, the Rule contains technical requirements on topics such as creation units, baskets and custom baskets, and disclosure of portfolio holdings and bid-ask spreads (see below for more).

“The exemption application process is time consuming and costly,” said Shearman & Sterling partner Jay Baris. “The proposed Rule, if adopted, would streamline this process. In some ways, the Rule would reduce the regulatory burden on industry participants who want to enter the ETF world. In other ways, the regulatory burden may increase, because ETFs would be required to make additional disclosures concerning trading information and trading costs.”

“The Rule is a good thing, and overdue for a multi-trillion dollar industry that operates on a bunch of exemptive orders,” said Morgan Lewis partner John McGuire.

Why did it take so long for the SEC to propose the Rule? McGuire attributed the delay to the 2008 financial crisis, saying that the Commission was set to propose an ETF Rule before then, but “then the financial crisis hit, then Dodd-Frank and the JOBS Act, the flash crash – which some incorrectly attributed partially to ETFs, and a shift by the agency toward enforcement. Everything that Congress pushed onto the SEC prompted the agency to work on things other than ETFs.”

Several industry associations, including the Investment Company Institute (ICI), which represents funds; and the Securities Industry and Financial Markets Association’s Asset Management Group (SIFMA AMG), which represents U.S. and global asset management firms; and the Mutual Fund Directors Forum (MFDF), which represents independent mutual fund board directors, along with multiple private firms and individuals, sent comment letters to the SEC with their thoughts on the Rule.

Support and recommendations

The ICI, in its comment letter, came out strongly in support of key parts of the proposed regulation, including:

  • Equal treatment for both index-based and actively managed open-end ETFs. “We strongly agree with the Commission that permitting index-based and actively managed open-end ETFs to operate under the proposed Rule subject to the same conditions would provide a level playing field among those market participants,” the association said.
  • Establishing a definition of a “creation unit.” ICI noted that the proposed definition does not incorporate a minimum size. This “gives an ETF flexibility to set its creation unit size at an amount that the ETF believes to be appropriate based on its investment strategy, type and availability of basket assets, and the authorized participants (and other market participants) that are expected to engage in creation and redemption transactions with the ETF.”
  • Adopting and implementing ETF policies and procedures for ETF basket composition. These would cover the methodology that an ETF would use to construct baskets, such as the circumstances when a basket might omit positions that are not operationally feasible to transfer in kind, “when the ETF would use representative sampling of its portfolio to create its basket, and how the ETF would sample in those circumstances,” the ICI said.
  • Permitting ETFs to use “custom baskets” that do not reflect a pro-rata representation of the fund’s portfolio. This would “help improve efficiency and tradability while lowering costs and enhancing tax benefits for investors,” the association said.

In the same comment letter, however, the ICI also made a number of recommendations for steps it would like to see the Commission take in regard to ETFs. These were:

  • Alternative disclosures to help investors understand ETF trading costs. These would be narrative disclosures that would include transactions fees and costs for ETFs that are not reflected in the Form N-1A fee table, such as brokerage commissions, bid-ask spread, and costs attributable to premiums and discounts.
  • Urging the Commission to consider streamlining ETF regulation under the Securities Exchange Act and the Investment Company Act. The proposed Rule would allow ETFs to operate under the scope of only the Investment Company Act. “We believe that automatic relief from certain Securities Exchange Act rules could be warranted,” the association said. “Currently, ETFs often must satisfy multiple and sometimes conflicting requirements from different divisions within the SEC.”

The comment letter from SIFMA’s Asset Management Group, which said that it “strongly supports the object of the proposal” in permitting ETFs to operate without the expense and delay of obtaining an exemptive order and to level the playing field for new and existing ETF sponsors, had a number of “specific comments and suggestions” of its own. These focused on creation and redemption issues, as well as disclosure issues, and included:

  • Custom basket reviews. The association said that it “does not support the provision of the proposed Rule that requires ETFs to identify the titles and roles of the employees of the investment adviser who are required to review each custom basket for compliance with the ETF’s custom basked policies. The asset management group said that “it is impractical to have individual employees review each customer basket prior to approval.” Instead, it said, ETFs should be required to identify the titles and roles of the employees who are responsible for approving custom baskets that deviate from the parameters set forth in the custom basket policies, but which are nevertheless in the best interest of the ETF and its shareholders.
  • Use of cash or “cash in lieu.” “AMG believes that the use of cash or cash in lieu in creation and redemption baskets does not present the same potential for ‘cherry picking’ and ‘dumping’ by authorized participants” as it might in other circumstances, the association said. The proposed Rule’s treatment of partial cash or cash in lieu baskets as “custom baskets” subject to custom basket policies “elevates a routine portfolio management prerogative to the same level as transactions that present a greater potential for conflicts and overreach.”
  • Disclosure of portfolio holdings. “AMG is concerned that the requirement to post portfolio holding and basket information prior to accepting creation and redemption orders will result in significant operational challenges, particularly for ETFs that invest in non-U.S. securities,” the comment letter said. It recommended that the SEC revise the proposed Rule so that ETFs would be required to publish portfolio holdings “as soon as practicable, but in no event later than the opening of the U.S. trading markets . . . rather than prior to accepting creation or redemption orders.”
  • Basket disclosure. The association said that it has a number of concerns about a requirement in the proposed Rule that ETFs publish a basket on its website that it would exchange for orders to purchase or redeem creation units. “AMG does not support the requirement to publish a custom basket if the ETF ‘planned to use only custom baskets’ on a given day,” it said. Instead, it suggested that ETFs be required to publish either a pro-rata, representative sample or an optimized transactional basket each day.
  • Historical bid-ask spread disclosures. The association said that it is “concerned with the utility of including the proposed historical bid-ask spread disclosures in ETF prospectuses. AMG believes that the one-year look back might not be informative since backward-looking bid-ask spread disclosure does not inform a retail investor about what their costs will be now.” Instead, it recommended, the Commission should adopt a shorter, more relevant look-back period, such as the most recent 45 days.”

The Mutual Fund Directors Forum, in its comment letter, largely supported the proposed ETF Rule.

“We strongly agree that the exemptive relief necessary to introduce and manage ETFs should be codified,” it said. “At this point, ETFs are well-established in the market, and the processes by which they are organized, managed and traded are well-understood. . . . There is little reason that advisers should not be able to create and offer ETFs with the same relative ease available to other types of registered investment companies.”

The association did say that it hoped the ETF Rule “represents a signal from the Commission that other forms of routine exemptive relief will be converted to rule form. Once the Commission has issued a specific type of exemptive relief multiple times, and hence has presumably determined that the relief is in the interest of fund shareholders, there is little reason to withhold that relief from the remainder of the fund industry.”