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Mutual fund directors and investment advisers digest

Impact of the Proposed Rule 6c-11 on ETFs

The exchange-traded fund (ETF) market received news of the beginnings of a long-awaited change to the way they are regulated and go to market. The Securities and Exchange Commission (SEC) recently offered the investment management industry the opportunity to comment on a proposed ETF rule.

The proposed ETF rule

The proposal “is designed to create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs.”1 This proposed rule will enable ETF providers to go to market more quickly, reduce barriers to entry, and pave the way for operational efficiency. Let’s explore some of the significant market impacts that these proposed changes may have on the investment management industry.

Analysis of the impact of this proposal should keep in the forefront that this is a proposed rule, and that the SEC seeks feedback from the industry. The proposal contains approximately 700 questions for industry participants in its 261 pages. For firms familiar with Deloitte’s regulatory ready research this proposal is squarely in the sensing and influencing stage.2

Market impact

The potential impact of exemptive relief for investment managers is significant. As of December 2017 there were 1,900 ETFs registered with the SEC, operating under 300 exemption letters granted by the SEC.3,4 Not all ETFs are affected by the proposal, such as ETFs structured as unit investment trusts (UITs). The cost of an exemptive relief letter to an investment manager is estimated to fall between $20,000 and $75,000.5 The real benefit, however, may not be the savings based on the exemptive orders themselves, but instead the savings associated with standardization of industry processes and procedures through operational change.

Creating and processing of custom baskets will likely benefit from economies of scale over time, given the opportunity to standardize processes across many formerly different ETFs. This savings is offset by the cost associated with complying with other reporting components of the proposed rule, though it is likely the savings outweigh this cost.

The proposed rule streamlines challenges currently associated with ETFs such as different treatment of active and index ETFs and custom basket utilization. The market may benefit from the significant opportunity afforded through lowering costs associated with operations, increasing competition, and encouraging innovation. Investors could benefit from these changes through potentially lower operating costs, which will support the competitive pressure for lower fees and greater investment choices in the ETF market.

The proposed changes in the SEC rules may allow ETFs to accommodate additional types of investment strategies. This should allow the industry to better address tax efficiency issues in light of the comparative advantage ETFs have in this area. The flexibility the SEC is proposing around creation and redemption unit transactions involving non-pro rata custom basket transactions should allow for greater tax efficiency for the benefit of individual investors.

One of the changes addressed by the proposal includes standardizing the creation basket regulation and allowing the use of flexible baskets for creation and redemption by authorized participants. This flexibility will be governed by written fund level policies and procedures. It may also lead to increased liquidity for ETFs by facilitating the arbitrage process for authorized participants.

Being important stakeholders in the ETF market, ETFs will likely work with authorized participants to improve the process within the newly afforded flexibility. This change will level the competitive playing field among ETFs currently operating under differing exemptive relief requirements. The proposal provides more latitude in creating a basket that doesn’t have to mirror an index, which may allow some actively-managed ETFs to operate in a more efficient and cost-effective way.

There is likely to be an impact beyond the ETF market as a result of this proposal. With an expanding ETF market, lower costs, and more informed investors, a shift in investor demand towards ETFs is an important point to consider. The impacts would be seen by broker-dealers and investment advisers whose customers may show greater interest in the economic advantages offered by ETFs. Investors may further shift from mutual funds to ETFs, if the proposed amendments are adopted. This shift to provide the products investors favor also impacts the economic model for brokerage firms and investment advisers.

One wildcard aspect of the proposal is the uniform treatment of active and traditional index-based ETFs. There still appears to be a significant freeriding opportunity that will likely hamper active equity ETF development. (Freeriding occurs when investors can replicate the investment portfolio, without investing through the fund.) Active bond ETF formulation will likely be less inhibited by potential freeriding, due to the difficulty in replicating a large bond portfolio. However, there may be some interesting combinations of holdings and acceptable custom basket transparency that support active equity managers and fulfill the goals of the SEC.

As it stands, we predict that most new ETFs under the proposed rule will likely be either traditional passive index ETFs or enhanced beta products. Whether the rule changes the desire of active equity managers to publish in the future fund holdings on a daily basis remains to be seen.

From a board perspective, the proposed rule does not add any new obligations to boards overseeing ETFs. However, there may be an inherent expectation that an ETF board will play a role in the oversight of the custom basket process, likely through the review of established policies and procedures in accordance with the proposed rule. ETF boards may also want to review the investment adviser’s processes for monitoring and tracking custom baskets. Boards may have a responsibility to ensure their construction and acceptance are in the best interest of the ETF and its shareholders.

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Call to action

The SEC has provided an opportunity to deliver feedback and help shape a potentially highly impactful regulation. We encourage all to consider how this proposal will impact your business and investors. Assessing this proposal with both near-term changes and long-term strategies in mind may enhance the impact of the regulation to your organization.

The due date for comments on this proposal to the SEC was October 1, 2018. While the comment period has passed, it is not too late to submit comments as the SEC generally still reviews comment letters submitted shortly after the deadline.

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Endnotes

1 SEC, Release Nos. 33-10515; IC-33140; File No. S7-15-18, RIN 3235-AJ60, Exchange-Traded Funds
2 Reference “Regulatory Ready IM firms” Deloitte Insights
3 Bloomberg data
4 SEC
5 “SEC may make it easier to create exchange-traded funds,” MarketWatch https://www.marketwatch.com

Authors

Paul Kraft
Partner
US Mutual Fund & Investment Adviser practice leader

Tom Driscoll
Partner
International Tax

Doug Dannemiller
Senior manager, research leader
Investment Management

Lauren Jackson
Senior manager
Audit & Assurance

Contributors

Maria Gattuso
Partner
Risk and Financial Advisory

Ryan Moore
Partner
Audit & Assurance