The $4 trillion exchange-traded fund industry has, for the last 27 years, operated via a quirk in the law. After some dramatic back-and-forth this week, the Securities and Exchange Commission has finally changed that.
The 2,273 ETFs on the market today have essentially been created via a loophole in the law that governs mutual funds and other investment products for individual investors. The much-hyped and long-awaited “ETF Rule” was supposed to change that, making it easier for companies to create new products. After canceling an open meeting scheduled for Wednesday to vote on this proposed regulation, the SEC announced on Thursday that it has in fact adopted the ETF Rule, more officially known as Rule 6c-11.
“It is arguably the most important piece of regulatory action to hit the ETF industry since 1993,” says Dave Nadig, who is managing director of ETF.com. “It’s a rare win for both investors and the industry.”
Broadly speaking, ETFs have been beholden to the same rules as mutual funds, via the Investment Company Act of 1940—but with a major asterisk. Because ETFs are different than mutual funds in myriad ways, issuers have been required to apply for “exemptive relief” with the SEC. “It’s basically a fancy way of saying ‘getting permission to break the rules,’” says Nadig.
Since 1992, the SEC had issued more than 300 exemptive orders allowing ETFs to operate. That additional step drove up the time and cost of launching new ETFs—even when they were similar to funds launched by other firms. “Each ETF was essentially being treated as if it’s a snowflake, where nothing is the same, and it slows down the process,” says Todd Rosenbluth is director of ETF and mutual fund research at CFRA.
This dynamic also created an environment where some ETF providers were subject to more stringent regulations than others, based on the deals the firms struck at various points in time. “All have slightly different things they’re allowed to do because they applied for exemptive relief at different times with different commissioners,” says Nadig. The early entrants, he says, generally got very broad exemptive releases, while providers that have filed more recently have been held to stricter standards.
The ETF Rule scraps all of that and holds most ETFs—the primary exceptions being leveraged and inverse funds—to the same regulatory framework. One year after the rule’s effective date, the SEC is rescinding the exemptive relief it had previously granted. At that point, most ETFs will be following the same playbook.
This change offers an immediate benefit for existing ETFs that were subject to more stringent rules than their peers. It also removes barriers to entry for newcomers who might have been deterred by the additional cost and complexity of filing for exemptive relief.
“One of the biggest positives that will come out of the rule will be the availability of custom creation and redemption baskets for all issuers,” says Jordan Farris, head of ETFs at Nuveen, which launched its first ETFs in 2016 and now has a dozen ETFs, primarily focused on enhanced income and environmental, social, and governance, or ESG, factors. “It will essentially level the playing field between those who have received their exemptive relief within the last several years versus those who received it 10 or more years ago.”
Investors should ultimately benefit, says Rosenbluth. While ETF fees are already low, the new ETF Rule could help nudge them still lower yet—by reducing the upfront costs of launching a fund, opening doors for more competition and allowing funds to use custom baskets to minimize trading costs.
It also potentially improves more transparency by requiring issuers to disclose on their websites historical information related to bid-ask spreads, and premiums and discounts to net asset value.
A little last-minute suspense
In June 2018, the SEC voted unanimously to propose the rule, which garnered wide support from the industry and the investment community. Following a comment period, the SEC was expected to vote on the rule in an open meeting scheduled for Wednesday.
For self-described “ETF nerds” like Nadig, it was supposed to be the Super Bowl of ETFs. Nadig, who was traveling in Italy with his wife, even planned to skip dinner that evening to watch the action live.
Then, without explanation, the meeting was canceled the day before the big event. Following the collective groan of disappointment, ETF super fans started to hear rumors that the SEC would indeed adopt the rule, though possibly behind closed doors. Those rumors were validated on Thursday morning with the SEC’s big reveal.
Customization is key
The biggest sticking point with the previous regulation—or lack thereof—related to whether an ETF can use custom baskets. ETFs are able to minimize trading costs and improve tax efficiency creating and redeeming shares through authorized participants. Typically, they do this with a basket of securities that mimics the rest of the portfolio, but that isn’t always feasible, says Ed Baer, an attorney in Ropes & Gray’s asset management group in San Francisco.
That’s where custom baskets are key. In the case of an actively-managed fund, for example, the manager may want to sell a specific security and buy a new one. A fixed-income manager may find that the bonds it needs to buy aren’t even available. “It’s very difficult to operate a fixed income fund with without the ability to engage in custom transactions,” Baer notes.
In 2012, the SEC stopped issuing exemptive relief that permitted custom baskets. Firms that had issued ETFs before that have been able to apply that to future funds, but more recent entrants didn’t have that option.
Under the new rule, ETFs have the option of using custom baskets. “This change is a huge boon for younger firms,” says Nadig, who thinks this could open doors for more actively-managed ETFs.
With thousands of ETFs already on the market, why should investors be excited about regulation that opens doors for still more? “We do have too many products,” says Rosenbluth, “but under the rule the market’s going to decide what’s going to be successful, not regulators.”
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