Starting an exchange-traded fund is about to get a little easier. Finally.
More than 10 years after regulators first considered a plan to streamline ETF approvals in the U.S., the Securities and Exchange Commission is readying a proposal that will shave months off the process and end inconsistencies that have created an lopsided playing field.
But one quirky provision could expose investors to a new risk -- fund managers admitting substandard securities into existing ETFs for reasons that have nothing to do with what’s best for the portfolio.
Since the first ETF started trading 25 years ago, they’ve exploded into a $3.4 trillion industry of more than 80 U.S. providers. There was no ETF-specific rule when they began, so they operated under an exemption to the Investment Company Act of 1940. Little has changed since then, even as they’ve become bigger and more complex and have drifted away from mutual funds.
So adapting regulations to the new ETF industry was all but inevitable. The question is, do the benefits for issuers and investors outweigh the potential costs?
“The world’s largest asset managers recognize the downside of something like that is far bigger than the upside, but what about a startup?,” said Mo Haghbin, head of product at OppenheimerFunds Inc.’s beta solutions business. “There’s always a risk that someone does the wrong thing so, ‘How do you mitigate that risk?’ is the right way of thinking about it.”
Flexible Baskets
The Securities and Exchange Commission declined to comment. Dalia Blass, who leads the regulator’s investment management division, said in a speech last week that “delivering a recommendation to the Commission for a rule is a high priority for the division, and our ETF team is hard at work.”
Both issuers and investors are intended to benefit from the provision, which makes it easier for managers to choose the securities for their ETFs when they issue new shares and those they surrender when they destroy shares. While early adopters such as BlackRock Inc. and State Street Corp. already have some flexibility as to which securities they can admit or distribute, known as creating a custom basket, more recent issuers have to stick to a pro-rata slice of their portfolio.
This has put the newcomers at a disadvantage, as managers are forced to accept securities they already own or cash -- both of which can hurt the end-investor if they’re traded for, or invested in, other securities. There’s also a tax hit during redemptions. Bond funds in particular suffer under this regime as debt instruments can be hard to find and difficult to trade.
“The benefit of the custom basket is the tax efficiencies it can generate,” said Stacy Fuller, a partner at K&L Gates. “The division recognizes the necessity of leveling the competitive playing field for all ETF issuers, and they’ve really educated themselves on the value of custom baskets for ETF shareholders and become less wary as a result of having undertaken that education on the potential for custom baskets to be abused.”