ETFs are regulated by the Securities and Exchange Commission. The SEC’s Division of Investment Management regulates the investment companies that issue ETFs and the SEC’s Division of Trading and Markets regulates the trading-related aspect of ETFs. Both divisions require ETFs to comply with certain rules.
Division of Investment Management
The Division of Investment Management regulates all investment companies, including mutual fund companies, closed-end funds, and federally registered investment advisors. Because ETFs do not fit neatly into the regulations governing mutual funds and closed-end funds, EFT sponsors are required to obtain “exemptive relief” from the Investment Company Act of 1940 to operate an ETF. Sponsors typically submit a detailed application covering a broad spectrum of ETF products. The SEC approved the first index-based ETF in 1993, but did not approve the first actively managed ETF until 2008.
Basically, ETFs operate in a manner not contemplated when the Investment Company Act was passed in 1940. Exemptions from the act that ETF issuers commonly seek include:
- They need to able to issue share redeemable only in large blocks called creation units.
- They need permission for in-kind purchase and redemption of creation units with the ETF by Authorized Participants.
- They need permission to allow other investment companies to purchase shares of the ETFs in excess of the act’s fund of fund regulations.
As is the case with mutual funds, each ETF is required to file a prospectus. All investors who purchase shares receive a prospectus. Some ETFs may furnish investors with a summary prospectus, as long as the full prospectus is available on the issuer’s website and is available in print upon request and without charge.
Division of Trading and Markets
The SEC Division of Trading and Markets regulates all the major U.S. stock exchanges. Its purview includes listing rules for all securities, including ETFs. In general, as long as an ETF issuer has its proper exemptions (see above) and the ETF meets listing standards, an ETF can be listed once its prospectus is declared effective.
Important listing requirements for domestic equity index ETFs include:
- Component stock that in aggregate account for at least 90% of the index shall have a minimum value of $75 million and a monthly trading volume of at least 250,000 shares.
- The most heavily weighted stock shall not exceed 30% of the weight of the index and the five most heavily weighted component stocks shall not exceed 65% of the index.
- The index shall include a minimum of 13 component stocks.
Important listing requirements for global equity index ETFs include:
- Component stocks that in aggregate account for at least 90% of the index shall have a minimum value of $100 million and a monthly trading volume of 250,000 shares.
- The most heavily weighted stock shall not exceed 25% of the weight of the index and the five most heavily weighted component stocks shall not exceed 60% of the index.
- The index shall include a minimum of 20 component stocks.
Important listing requirements for fixed income index ETFs include:
- The index must consist of fixed income securities.
- Components that in aggregate account for at least 75% of the weight of the index shall have a minimum original principal amount outstanding of $100 million.
- A component may be a convertible security; however, once the security is converted to underlying equity security, it must be removed from the index.
- No component security (excluding Treasuries and Government Sponsored Enterprise Securities) shall represent more than 30% of the weight of the index, and the five most heavily weighted components shall not in aggregate account for more than 65% of the index.
- An underlying index or portfolio (excluding one consisting entirely of exempted securities) must include a minimum of 13 non-affiliated issuers.
ETFs that do not meet the generic listing standards must receive specific permission from the SEC before listing on a stock exchange. Typically, the ETF sponsor will collaborate with the exchange on the specific rules regarding the fund, and the exchange files a 19b-4 filing with the SEC Division of Trading and Markets to amend the exchange rules.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.