The ETF market, which has surged to $4 trillion in assets under management (AUM) amid a series of price wars, is poised to grow even faster and cut fees more deeply in the wake of a new rule passed by the SEC. “It is arguably the most important piece of regulatory action to hit the ETF industry since 1993,” as Dave Nadig, managing director of ETF-focused financial website ETF.com, told Barron's. “It’s a rare win for both investors and the industry,” he added.
“As the ETF industry continues to grow in size and importance, particularly to Main Street investors, it is important to have a consistent, transparent and efficient regulatory framework that eliminates regulatory hurdles while maintaining appropriate investor protections,” SEC Chairman Jay Clayton said in a statement, as quoted in a detailed report by ETF.com.
Significance for Investors
The Investment Company Act of 1940 set rules for mutual funds, but did not envision ETFs, which first hit the U.S. market in 1993. As a result, each new U.S.-based ETF has required a lengthy, costly process of applying for "exemptive relief," or a waiver, from certain provisions of the 1940 Act.
“Each ETF was essentially being treated as if it’s a snowflake, where nothing is the same, and it slows down the process,” as Todd Rosenbluth, director of ETF and mutual fund research at CFRA, told Barron's. “All [ETFs] have slightly different things they’re allowed to do because they applied for exemptive relief at different times with different [SEC] commissioners,” Nadig said, per the same report. In general, the oldest ETFs got much broader exemptive relief than newer entrants, he observed.
The new "ETF Rule," technically SEC Rule 6c-11, replaces that inefficient "exemptive relief" process. “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,” as Jordan Farris, head of ETFs at Nuveen, was quoted in that article.
When an ETF creates or redeems shares, it typically has to adjust each of its perhaps hundreds of security positions proportionally, a process that can be costly and inefficient. Such action can trigger capital gains tax liabilities for investors. Also, a wave of buy or sell orders in less liquid securities can move their prices against ETF investors, raising the cost of creations and lowering the proceeds from redemptions. This is a particular problem for fixed income ETFs.
Under the new rule, an ETF can process creations or redemptions through a custom basket that contains a subset of its holdings, such the most liquid securities, if it discloses this to investors and demonstrates how it will be beneficial to them, ETF.com indicates. Prior to 2012, the SEC typically allowed their use, but stopped issuing exemptive relief for them thereafter.
Meanwhile, complex ETFs that use derivatives or leverage will continue to face a lengthy approval process, Bloomberg notes. All ETFs will have to disclose more information about trading costs.
“It [the new ETF Rule] 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,” Jordan Farris asserts. Todd Rosenbluth agrees. He sees benefits for investors as the upfront costs of launching a new fund drop, thereby stimulating competition, and more widespread use of custom baskets leads to improved performance.