Dave Nadig's Deep Dive On New ETF Liquidity Rules

When the SEC published draft rules for mutual fund and ETF liquidity last year, I was less than complimentary. I pointed out that, for instance, virtually all corporate and high-yield bond ETFs would fail to meet the requirements on illiquid assets.

That rule is sailing through (with some small changes) for mutual funds, but the press is reporting that ETFs got a pass. That’s not quite true.

Some Background
The original proposal—and the current version—focused on all open-ended funds maintaining a liquidity risk management program with the intent to ensure that it could always meet shareholder redemptions in an orderly fashion.

It was a clear response—or convenient timing at least—to the shenanigans that happened to Third Avenue’s mutual fund in the summer of 2015, when it closed for redemptions because it couldn’t sell its junk bonds fast enough.

The original proposal received an enormous amount of industry commentary, and rather than publishing a revised rule for comment, the SEC simply published a final rule, which will go into effect for most funds in December 2018.

The key components of the final rule are threefold:

1. Rules that ensure a fund always have highly liquid securities to meet redemptions
2. Rules that ensure a fund doesn’t have more than 15% of its investments in illiquid investment
3. A reporting regime that has funds classify all of their positions at least monthly and report each security as belonging to one of four liquidity buckets (the two above and two in the middle)

Much of what the SEC requested was pretty noncontroversial; however, the ETF industry argued in its various comment letters that since ETFs meet redemptions generally by in-kind transfer of underlying securities, it should be exempt from large swaths of the program.

They got a small slice of what they wanted, and it will have significant implications.

What About The ETF Get-Out-of-Jail-Free Card?
The SEC has defined for the first time a class of ETFs it refers to as “In-kind ETFs.” In-kind ETFs are those that use only a de minimis amount of cash in any redemption activity. The commission goes out of its way to say that it really means this: If you regularly use cash redemptions, you’re not covered here.

The second big issue is that, to qualify, you must publish your complete portfolio every single day—the same transparency standard the SEC has so far held actively managed ETFs to.

If you’re an in-kind ETF by this definition, you can sort of avoid two components of the program: You don’t have to hold a bunch of highly liquid investments to meet redemptions, and you don’t have to classify all your portfolio holdings.

I say "sort of" because the wording of the final rule is, in my opinion, a bit different than the actual discussion of the rule in the SEC’s 400-page final rulemaking document. The actual rule simply says in-kind ETFs can consider the fact that they can redeem-out shares when drafting their liquidity risk management program. It doesn’t actually say in-kind ETFs are exempt from holding those highly liquid assets or that they don’t have to comply with the fairly onerous reporting process.

I imagine that will get cleared up and clarified, but it’s frustrating when the final rule doesn’t match the stated intent. But let’s assume that ETFs get at least a little relief there.

The Big Whammy: The 15% Rule
So what’s the big deal? The 15% illiquid cap is problematic. There’s an enormous amount of wiggle room in how to meet the assessment that a given position can be liquidated without significant impact in seven days, and all that wiggle room lands on the fund board to interpret.

The SEC discussion clearly shows that the commission understands it could be upsetting the apple cart, going so far as to say some funds will have to consider closing:

“In circumstances in which it appears unlikely that the fund will be able to reduce its illiquid investment holdings to or below 15% within a period of time commensurate with its redemption obligations, a fund’s periodic liquidity risk review could lead the fund to reconsider its continued operation as an open-end fund.”

So Who Could Get Hit Hardest Here?
There are two groups that have an immediate problem. The first is ETFs that invest in less liquid securities. Funds that invest primarily in high-yield debt or bank loans may be able to argue that they can unload their whole portfolios without impact, but ultimately fund boards will have to decide how much risk they want to take in defining liberal interpretations of “illiquid.”

The second issue is large funds. Because there’s no scaling here, funds that are very large have a much higher burden than small funds. I can own 100 shares of the most illiquid microcap and probably claim correctly that I could find a buyer in week. Not so for a $100 billion fund trying to own a proportionally similar position in the same company.

This second issue is a big one, particularly for Vanguard. Vanguard’s ETFs are share classes of mutual funds. My assumption is that the root fund is what will have to make the test, not each individual share class, so it won’t get the pass on the reporting or highly liquid requirements. And Vanguard will be hit harder on the 15% illiquid cap than it would if its ETFs were in fact separate funds.

While most of Vanguard’s 70 ETFs are in highly liquid corners of the market, it’s possible that funds like the Vanguard Small Cap Index Fund (VB) or the Vanguard Short Term Corporate Bond Index Fund (VCSH) could face real hurdles. When I ran the volume numbers on VCSH holdings last year, I estimated that even swamping the market, it would take VCSH 16 days to trade out.

So without market impact, that’s probably a multiple—clearly a fund that probably won’t be in compliance without a pretty liberal interpretation of how the short-term corporate markets can absorb big sales.

Could Vanguard solve this problem? It would be tricky. It would need to spin the ETFs out and adopt full disclosure. That’s a lot of work to save a few funds. Then again, I’m not sure what the options are.

In the end, it does seem like ETFs dodged a BB here, if not a bullet, but the ripples from this earthquake will be felt for quite some time. I’m not suggesting we’ll see a huge raft of fund closures, but at a minimum, it’s a good year to be a lawyer advising fund boards.

At the time of writing, the author held no positions in the securities mentioned. Dave Nadig is the director of exchange-traded funds at FactSet Research Systems. You can reach him at [email protected], or on Twitter @DaveNadig.