The SEC ETF Rule is approved

December 18, 2019

An article by Lauren Jackson, Paul Kraft, and Doug Dannemiller

A long-awaited change and opportunity for the exchange-traded fund (ETF) industry is finally here with approval of Rule 6c-11 (the ETF Rule) by the Securities and Exchange Commission (SEC) on September 25, 2019. The ETF Rule allows asset managers to bring ETFs to market without the cost and delay of obtaining exemptive relief, which now includes inverse and leveraged ETFs. According to data from the SEC, more than 300 exemptive orders for ETFs have been issued by the SEC to operate under the 1940 Act since 1992.¹ As a result, ETF sponsors will be able to get their products to market quicker and more efficiently. In this Quicklook article, we cover key takeaways of the final rule as well as opportunities and challenges for the ETF market.

The essentials of the rule

In order to create a consistent ETF regulatory framework, the SEC will rescind exemptive relief from those ETFs that fall under the scope of Rule 6c-11. The ETF Rule will be available to ETFs organized as open-end funds. Those ETFs organized as unit investment trusts, leveraged or inverse ETFs, ETFs structured as a share class of a multi-class fund, and non-transparent ETFs will not be able to rely on the rule. ETFs structured as funds of funds will maintain their existing exemptive relief; however, the SEC will be rescinding exemptive relief thus permitting ETFs to operate in a master feeder structure (certain existing master-feeder arrangements will be grandfathered in).

One significant difference between the proposed and final rule is that providers do not need to publish on their website information on custom baskets that they would exchange for purchasing and redeeming creation units. This relieves much of the industry’s concern on the proposed rule.

Another key change from the proposed rule is that holdings information required to be posted to an ETF’s website does not need to conform to Article 12 of Regulation S-X, with which many commenters noted concerns regarding compliance burdens. In addition, the bid-ask spread disclosures were cut back from what was originally proposed, which included bid-ask examples and an interactive website calculator. Instead, ETFs will only need to disclose their median bid-ask spread during the last 30 calendar days on their website.

The ETF Rule allows those funds relying on the rule to use custom baskets, as long as the ETF adopts written policies and procedures that are in the best interest of the shareholders. These policies and procedures must be included in the ETF’s compliance regulatory filings and reported to the board of directors. ETFs relying on the rule will need to publish their holdings each day, but they are not required to publish what is in the custom basket.

Another difference from the proposed rule is that the final rule does not require the daily holdings to be published to EDGAR. They only need to be published on the ETF sponsor’s website. An ETF's board should oversee these policies and procedures for custom baskets. The ETF Rule also requires disclosure of other information on the ETF’s website, including lookback information on bid-ask spreads and premium and discount trading information, all of which is intended to inform investors about the costs of investing in ETFs and facilitate the arbitrage process.

The final rule, like the proposed rule, does not require ETFs to disseminate an intraday indicative value (IIV), an estimate of the NAV of the ETF based on the price of the underlying securities, because of concerns the SEC has on the accuracy of those estimates for certain ETFs. For securities that trade less frequently (and do not trade contemporaneously with the ETF)—for example, foreign securities whose markets are closed during an ETF’s trading day—the IIV can be stale or inaccurate. Many mutual fund sponsors have policies and procedures in place to monitor and evaluate if a foreign equity price should be adjusted from its closing exchange price, but these policies can vary with ETF sponsors. Also, such a procedure itself, if performed at the end of the day, will be stale to the publishing of an IIV that occurs many times a day. Though not required, it does bring up an interesting point for fund sponsors as to whether ETFs need a different set of policies and procedures from traditional mutual funds. To the extent that current exchange listing standards require IIV to be disseminated, the ETF Rule’s omission does not equal a change in this requirement.²

Opportunities and Challenges for the ETF market

The SEC does not distinguish between active and passive ETFs in the Rule, but the Commission does care about transparency. One of the biggest sticking points for active equity ETF development is the free-riding that can come along with public disclosure of fund holdings in real time. Disclosure of this information effectively destroys the value of the intellectual property associated with actively managed equity portfolios. Multiple avenues are currently being built to overcome this challenge.

Up until approval of The Rule, all ETFs were approved through exemptive relief, and non-transparent ETFs were severely restricted. The SEC has recently signaled it is receptive to new types of active non-transparent ETFs that do not disclose daily holdings with the approval of Precidian Investments’ ActiveShares ETF structure.³ As of October 6, 12 investment companies have signed licensing agreements with Precidian for their ETF structures, with another 24 signaling interest.⁴ This may open the door for active managers who have hesitated to venture into the ETF space for fear of making their investment strategies publicly available to competitors and potential investors alike, enabling free riding and dulling competitive edge. Many other financial services companies are seeking relief from the SEC for their actively managed non-transparent ETF structures, including Fidelity, T. Rowe Price, Blue Tractor, and Natixis.⁵ The SEC announced on November 14th that it plans to approve these structures. With multiple choices for active ETFs, active managers will likely raise the priority for evaluating the active ETF approach. These approvals serve to legitimize the non-transparent active ETF approach, invoking the fear of being left behind for many investment managers.

Many industry experts are predicting a shift in the landscape of the ETF marketplace.⁶ Index investing and ETFs may no longer be as closely linked as they were when ETFs first appeared. Active non-transparent ETF growth has the potential to change the playing field for investment management distribution but also faces headwinds. The system supporting active management distribution through mutual funds has adapted to regulatory changes over the past several years, and it is well established. Distributors have been driving share-class changes in mutual funds since the Department of Labor Fiduciary Rule first surfaced. Active non-transparent ETFs complicate this landscape with another form of “clean share” that distributors will have to consider as they act in the best interest of their clients.

As investment management firms evaluate any potential active non-transparent ETF offering, leading practices indicate that close coordination with distributor needs are part of the decision and development process. Additionally, the ongoing services that accompany active investments need consideration. Generally, ETFs don’t charge service or distribution (12b-1) fees that mutual funds often charge. If investors no longer pay for service and distribution through the fund expenses, then how will the service model change, and which firms will bear the costs? This change to the investment manager-distributor-investor dynamic is complex, and it may take years to settle into standard industry practices. In the meantime, active non-transparent ETF development will proceed but will likely be hampered since it is yet another change to the complex distribution dynamic. There is also potential for AUM cannibalization of traditional mutual funds. As the dust settles on the changes for traditional ETF approval and processing, the race is on for working active non- transparent ETFs into the product strategy.