SEC’s ETF Scrutiny Extends to Conversions, Single Stock Funds

The Securities and Exchange Commission’s scrutiny of the exchange-traded fund industry has widened to include mutual fund conversions and single-stock products, among others.  

The SEC has proposed a variety of rules since Chairman Gary Gensler’s confirmation in 2021. Among the Wall Street watchdog’s high-profile focuses include prospective disclosures for environmental, social and governance funds and their underlying companies and its constant denial of spot bitcoin ETFs. Still, its roster of regulatory scrutiny is set to expand as the Commission takes on the latest developments in the ETF industry.  

According to the regulatory agency’s recently released examination priorities for 2023, the watchdog has its eyes in issues including the growing number of mutual funds transitioning to ETFs, the proliferation of volatility-linked and single-stock ETFs.  

As ETF issuers create new products to meet investors’ increasingly specific demands, regulators are taking note and boosting oversight, Nate Geraci, president of the ETF Store, said in an interview with ETF.com. 

“Clearly the SEC is pursuing a much more aggressive regulatory agenda, we're seeing that everywhere across the markets,” Geraci said. “There's just been a proliferation of products and I think ETF issuers are continuing to push the envelope with these new and innovative ideas.” 

As more mutual funds are repackaged as ETFs, the SEC is monitoring how the switch is carried out along with governance of the new fund. Nearly 40 mutual funds have been converted to ETFs since the first switch in March 2021, according to ETF.com data. About $40 billion in assets switched in 2021 and 2022, and another $60 billion to $80 billion could convert this year, according to CFRA’s Head of ETF Data & Analytics Aniket Ullal.  

“All of these topics are relatively new, so I think they're careful,” Anthony Davalla, partner at law firm Thomson Hine said in an interview with ETF.com. “They go very slowly and are very careful whenever they're faced with a new type of development, whether it in this case it's mutual fund, ETF conversions, certainly the single-stock leveraged ETFs.”  

According to Steve Feinour, partner at Stradley Ronon in Philadelphia, queries into mutual fund conversions may cover disclosures and communications made to shareholders and funds’ governance changes, including potential conflicts of interest.  

“It's just a case of the SEC looking under the hood to see how these conversions are being conducted and get more information and insight with more detail and granularity,” Feinour said to ETF.com. 

Exemptive Relief, Single-Stock ETFs  

Another area of concern for the regulatory agency is exemptive relief, or permitting exemptions to rules that allow issuers to bring unorthodox products to market. ETFs which require exemptive relief include nontransparent funds, which do not disclose portfolio holdings daily, as compared with their more popular transparent ETF counterparts. Exemptive relief for non-transparent ETFs was specified as a topic of interest in the SEC’s release.  

Still, applicants seeking exemptive relief, whether for nontransparent products or otherwise, may face headwinds, according to Edward Baer of Ropes & Gray LLC.  

“I don't know that there's going to be more applicants looking for different types of relief because there's already, I think, six different ones out there,” he said to ETF.com. “At some point, I think there’s an oversaturation, potentially, where APs and market makers aren't going to necessarily want to support six different trading models, because it just adds complexity on their side.” 

APs refer to authorized participants, who create and redeem ETF shares. 

Also on the SEC’s regulatory docket is the evaluation of single-stock ETFs. According to Davalla, a potential point of scrutiny could be the investor and advisor trading surrounding the products.  

“Probably where the staff was looking is more the buying and selling of them,” he said. “Which is obviously not a fund concern, it's more of the advisor concern.”  

Potential questions from the SEC could be disclosures necessary for the products and whether investors “understand that things like leverage ETFs are really not intended to be long term investments,” Davalla added.   

Single-stock ETFs have largely failed to attract investor attention in the U.S., potentially due to SEC concerns around the product. At the end of 2022, only 26 single-stock ETFs traded in U.S. markets, with a total of $286 million in assets under management. 

The regulatory agency has repeatedly cautioned the potential downsides of the product, with SEC Commissioner Caroline Crenshaw saying “they are risky products for investors and potentially for the markets, as well,” in a July statement.  

Contact Shubham Saharan at  [email protected]