‘ETF Rule’ Playing Out Nicely, So Far

Federal regulation usually stifles business. Not this time.

[ETF Pulse appears Mondays and Thursdays. Drew Voros is Editor-in-Chief of ETF.com.]

I give credit where credit is due … and criticism where it is due. That’s my job. Today I’m going to praise the SEC, which may come as a surprise, as I have most recently criticized the agency’s bitcoin befuddlement.

Back in 2019, nearly two years to the day, the SEC approved what is known as the “ETF Rule,” which in its simplest terms would lower the threshold for entry by new and small issuers by eliminating the need for “exemptive relief” from the SEC, which took time and was costly.

What Changed

From our coverage on Sept. 26, 2019, the day the SEC passed this important regulation that is fueling growth today in the U.S. ETF industry (read: SEC Passes Landmark ‘ETF Rule’):

“The ETF Rule's most significant impact is the elimination of the exemptive relief requirement, in which would-be ETF issuers had to file with the SEC to get special permission to circumvent rules outlined in the Investment Company Act of 1940 (read: 'ETF Rule' Decision Postponed) …

Also, all ETFs now will be allowed to use custom baskets, or creation/redemption baskets that don't reflect a proportional representation of their portfolio or that differ throughout the trading day, as long as issuers publish written policies and procedures showing how these custom baskets are in investors' best interests.

By using custom baskets, ETF issuers can adjust their portfolio's holdings efficiently, spreading out the impact of big changes and minimizing capital gains from higher-turnover, active strategies. They were commonly allowed in the early days of ETFs, but around 2012, the SEC stopped issuing exemptive relief permitting them.”

When Change Matters

When the federal government steps into a national industry with new regulatory rules, it usually results in a stifling of that industry, adds to costs and rarely fuels growth, except for tax cuts.

But with the ETF Rule, we are seeing a positive impact, with new and smaller ETF issuers taking full advantage of the lower barriers to entry. While many have said that lower barriers will result in a higher threshold of success, we’ll have to wait for a few years to see how many of these newcomers are still standing.

We have had roughly 310 launches this year, with more on deck this week alone, and it likely won’t be long until we match the total number for all of 2020. More than 400 ETF launches this year is a real possibility—and one I would bet on. Roughly 200 of those new launches are active, and many are from smaller and new issuers.

More impressive is the drought in completed closures, which stand at 41, compared with roughly 200 at this time last year. (We ended up with a total of 275 at the end of 2020.)

Renaissance For New Issuers

Most new issuers today aren’t thinking about trying to take on the ETF issuer giants; rather, they’re hoping to carve out a niche in the ETF space using the most elegant and tax efficient investment vehicle yet created.

At least for now, we’re seeing this lowering of barriers to entry fueling more ETF launches than ever, which in turns feeds the ETF ecosystem, from index providers to market makers to custodians, etc.

Naysayers’ hand-wringing over a flood of launches because of the “ETF Rule” has materialized and very well could intensify in the next few years, as some of these new products will likely be pruned due to lack of assets and demand.

New firms looking to enter the space should define what they see as the parameters for success and failure. They should also come in with low expectations with regard to claiming market share and instead should focus on creating it. That’s how an industry grows.

Drew Voros can be reached at [email protected]