New ETF Rule’s Hidden Costs

On Thursday, the SEC released a new version of the “SEC Rule” to much fanfare. We’ve covered the core impact here and in a live chat shortly after, but at the time, the full 286-page rule was still making it through the series of tubes we call the internet.

After a few cups of coffee and a good long read, however, I think there are a few flies floating in what is an otherwise tasty soup.

The core idea of the proposed ETF rule is simple: All funds that meet certain requirements will be automatically covered by proactive “here’s how ETFs work” rules, instead of having to apply for permission to break a bunch of other SEC rules in order to operate (so-called exemptive relief).

This is great news for two reasons:

1. It makes launching new products simpler, easier, faster and cheaper.
2. It makes all ETFs play by the same rules, leveling the competitive playing field.

While both of these are inarguably both economic and competitive positives, the second one is the most important. For the most part, the ETF ecosystem had figured out how to make the ETF launch process relatively cheap and painless in the past 10 years.

Where once it might have taken more than a year, and a fat, six-figure legal bill, both the time and money involved has collapsed over the years. It’ll get cheaper still, but it wasn’t keeping upstarts like Exponential ETFs out of the business.

Custom Baskets

The second issue is much more interesting. The big headline is “custom baskets.” In short, when ETFs create or redeem shares through authorized participants, there’s a basket of securities that change hands.

Most of the time, that basket is a miniature version of the whole portfolio the ETF owns. So an S&P 500 ETF basket for either creation or redemption might be 500 stocks, in the correct weights. That’s what’s called a “pro rata slice” basket.

Older ETF firms, like BlackRock and State Street Global Advisors, have had the ability to do custom baskets for years, but newer firms couldn’t because the SEC wouldn’t give them that authority. A custom basket is one that, for whatever reason, doesn’t match the full portfolio.

Flexibility Tool

There are actually a lot of reasons you might want this flexibility as a portfolio manager:

1. Your portfolio is enormous (say, big bond funds), so you’d like to just have a selection of portfoliolike securities.
2. You’re trying to get rid of one security and replace it with another (active management, rebalancing, etc.). In this case, you might put a lot of the hated security in the redemption basket, and put a lot of the desired security in the creation basket.
3. An authorized participant shows up with a giant pile of securities (perhaps from an institutional customer) that don’t perfectly match the fund, which you’d like to accept to make the client’s life easier.

Using custom baskets can improve fund efficiency in two important ways. First, it can minimize internal trading costs. While these are small (often sub-basis-point in a large fund), they’re nonzero, and it is your money after all.

Second, it can make the AP/market maker’s transaction more efficient; this theoretically can lead to tighter spreads, which is always good for investors.

Big (Possibly Quite Big) Gotchas

To get the benefits of the new rule—particularly custom baskets—ETFs must meet certain conditions. The biggest one is around disclosure. Buried in the current proposal, here are the various things that an ETF will have to do that they might not be doing today:

1. Written policies and procedures around custom baskets (P.94): This is entirely new stuff, and it will rack up a lot of nice legal bills for fund lawyers. These new documents will have to cover essentially all possible reasons a fund might use a custom basket, from liquidity issues to rebalances, to “because we want to” in a rigorous, holds-up-to-scrutiny fashion. This could actually be quite restrictive for larger firms that’ve grown used to having a lot of discretion, and quite expensive to document and monitor for smaller firms.

2. Basket disclosure (P.103): While many ETFs publish their full holdings daily, not all ETFs are actually required to, by their exemptive relief. Under the new rule, every ETF will have to publish their creation and/or redemption basket each morning before the open. If this basket is a “custom” basket, so be it. Operationally (and this is in the weeds here), this is a big change. Last night’s portfolio is something that comes from your custodian/fund accountant. It’s a data feed you can set up, get a .CSV file into your publishing engine and forget about. The actual baskets, however, are a more complex process that involves a human portfolio manager reviewing a list each morning and making some decisions about what to include, how much cash to ask for and so on. Getting this done, and done correctly, by 9:30 a.m. ET every trading day is hard.

Currently, these baskets go out through the NSCC system, which in turn sends them to data vendors like Delta One, who cleans them up and sells the basket data back to the institutional investor and market-maker community in a standardized format. This new requirement throws an interesting, and potentially expensive, grenade into the whole ecosystem.

To make matters potentially worse, in the request for comments, they hint they might require ETFs to disclose, after the fact, any deviations from the day’s published basket that was used during that day. This, again, is an entirely new operational workflow.

3. Trading disclosure (P.107): The SEC has discovered that the internet is kind of a big deal. Different exemptive reliefs have required different kinds of disclosures over the years, and this rule will standardize—and complicate—those disclosures. The big ones are:

                Premium/Discount: The rule requires market price, net asset value and the derived premium/discount to be published each day, and historical data made available. The first problem here is that there are many reasons why P/D is a dumb statistic for some ETFs (international ETFs have timing issues, bond ETFs have pricing issues, and so on). Still, many ETFs do this reporting now as a matter of course; however, implementation among small issuers is spotty. The giant monkey wrench is that the definition of market price is changing from “closing price” to “closing price, or bid/ask midpoint if closing price is bad.” While this is theoretically awesome for investors, and avoids spurious premium/discount prints, it could be a real pain to administer. The rule goes on to suggest they’re considering intraday premium/discount calculations and summary statistics, which, well … don’t even get me started.

                The bigger issue around the premium/discount requirement is that every ETF needs a system to flag the website if the premium/discount exceeds 2% for more than seven days. These kinds of triggers sound great on paper, but they’re a real headache for any web-publishing process. This will put small issuers in the position of having to remember to do this manually, and will end up with lots of room for human error.

                Bid/Ask Spread: The rule says that median bid/ask spread for the prior year be disclosed. On the surface, this sounds great. But I have personal experience trying to actually calculate this statistic from the tape, and let me tell you, it’s a nightmare. For a fast-trading security, there can quite literally be millions of quote updates a day. The only “correct” way to calculate the median spread for today (much less a year) is to calculate how long each side of the best bid/offer dwells on the book, and then time-weight the quotes. Along the way, you need a pretty robust set of heuristics to filter out bad data. This is the process used on the ETF.com fund pages Trading tab (powered by FactSet). But more importantly, doing a median over a YEAR is a completely useless statistic. The median bid/ask spread changes, and it changes a lot.

Consider the B/A spread of the ETFMG Alternative Harvest ETF (MJ) over the past year:

Spreads collapsed from whole percentages to 30-40 basis points when the fund changed overnight from being a Latin American Real Estate fund to a marijuana fund (surprise!). How useful is the “median 1-year spread” here for investors? Not.

Worth The Lift?

Overall, I’m extremely pleased to see the SEC cleaning up Dodge after 25 years of frontier regulation. But as always, there’s a “be careful what you wish for” component to these things.

For small issuers, the carrot of custom baskets is probably worth the stick of the increased disclosure, but it will hardly be free to implement.

For larger issuers, I wonder if the constraints around how custom baskets can be used will chafe. Technically, the SEC is planning to automatically rescind any prior exemptive relief for funds that could be covered by the new rule when it goes live. That means the game could change quickly—both for the big guys and the newcomers.

How fast the SEC moves after the 60-day comment window expires is always anyone’s guess, but I suspect they won’t sit on their hands for long.

Dave Nadig is managing director of ETF.com. He can be reached at [email protected].