Live Chat: Dissecting The SEC Meeting

June 28, 2018

[Editor's note: Live! with Managing Director Dave Nadig happens Thursdays, with the question window available in the morning.]


Dave Nadig: Good afternoon folks, busy day in ETF land.
You can enter questions in the window below, and as always, we will have a transcript up soon after my fingers fall off from typing too much ...
So let's get started with the big issue of the day:


Darius Ellman: Hi Dave. What was the upshot of the SEC's decision today? Would it be positive or negative if new ETF issuers no longer need that exemptive relief?
Dave Nadig: So, for those of you NOT glued to the SEC website, they proposed a new ETF rule today (still not published, no matter how much I hit refresh).
In short, it would get rid of exemptive relief for most ETFs (for new applications as well as existing funds).
We have a full story up on, so I won't just rehash each detail, and get to the "what does it mean?" bit.
Once comments are done (60 days) and a final rule enacted (maybe by year end?), it will remove a whole set of processes for new issuers.
On the surface, this makes time to launch and cost to launch go down for new funds.
That said, this was a pretty well-established process already, so we're not talking ENORMOUS amounts of time and money saved, but a dollar and a day is a dollar and a day.
The bigger news is the leveling of the playing field around custom baskets. Which gets me to question No. 2 on my list here:


Todd Rosenbluth - CFRA Research: Dave - Can you give an example of how a custom ETF basket works and why the proposed SEC rules would make it easier for recently launched funds to work with institutional investors? Few better to explain to this audience than you.
Dave Nadig: So there's a lot of confusion around what a "custom basket" is --
Basically, it's any creation or redemption basket that isn't just a pro rata slice of the whole portfolio.
So why would an issuer want custom baskets? Several reasons:
1: Let's say you have an index rebalance, and you want to get rid of Microsoft, and get more Apple. You could put "too much" Microsoft in the redemption basket for the day, and "too much" Apple in the creation basket, thus letting the C/R process do some of your trading for you.
2: Let's say you want to take a HUGE creation unit from a big institution (through an AP). And that institution has, say, much more Apple stock than you really need. Custom baskets would allow you to take that "one off" creation unit and true it up internally.
Commissioner Stein represented the last part as problematic.
She was concerned that APs could "cherry pick" and "dump" into the ETF in a way that would be bad for investors, hence the requirement that there be a formal set of rules and procedures developed by each fund, and furthermore, that all of this be recorded and tracked so SEC examiners can come audit.
In general though, it's a good thing for funds as well as investors, and cleaning it up makes a ton of sense.
Feel free to toss any additional ETF rule questions in. I'll move on to a few unrelated issues that are fun:


Yellow Card: If you own a mutual fund share class, such as Vanguard, and want to convert to the exact same Vanguard ETF share class, can that be done without capital gains, or is simple selling a security for another?
Dave Nadig: This is a super fun question. So first off, right now this is ONLY a Vanguard problem, because they have a patent on the share class structure for ETFs.
(Further, they won't be affected by the new rules, as they were explicitly called out from it.)
The tricky thing is the answer is "yes, but one way" - You can take your, say "Admiral" shares at Vanguard, and convert them to ETFs.
You can do this tax free; it's just an in-kind transaction.
However, once you're in the ETF share class, you're locked in.
It's also worth noting that this process is pretty easy if you're a Vanguard brokerage customer, but significantly more confusing if you hold either your Vanguard mutual fund shares, or your stocks, in a different brokerage firm.
As for "why" you can't go from ETF shares back into mutual fund shares without making a round trip through cash, I've never gotten a super clear answer on that. I suspect it has to do with the fact that, by design, ETFs can never be redeemed in small lots, only in redemption units.


Lucy Carbone: With the momentous news yesterday about Justice Kennedy stepping down, and thinking about how many niche ETFs there seem to be, I was wondering if there are any government ETFs currently. I think there used to be a DEMS and maybe a GOP from RealityShares, but didn't they close?
Dave Nadig: Hi Lucy -- so you're right.
DEMS and GOP closed in April.
They were sponsored by "EventShares," and we were all a little stunned they closed so quickly, honestly.
They sort of combined all three of their ideas (the latter being TAXR, a tax-relief-based fund) into PLCY, which is designed to pick stocks based on the (admittedly capricious) U.S. economic policy agenda.
It's an interesting idea, especially because it picks losers -- not just winners -- to short.
But I'm pretty skeptical in general of "headline" funds.
Investors seem to be as well -- i don't think PLCY has managed to crack $20 million in assets yet.
Worth noting there's a competitor - MAGA.
MAGA is different, in that it's explicitly tied to campaign contributions, which -- again, not to be negative -- I'm not super convinced is a source of alpha, but if you're looking to chase politics, it's a way to do it.


Davis Angelo: Hey Dave, Since Canada only recently made cannabis legal, why is that country having more success with their marijuana ETFs then the U.S., since it's been legal in many states here for awhile now? Or is there not an implied relationship with that necessarily? Thanks.
Dave Nadig: So, it has less to do with cannabis and a bit more to do with the Ontario Securities Exchange vs. the SEC.
The issue is much less the ETF angle, and much more the public company angle, and the custodial system.
While cannabis hasn't been fully recreationally legal, companies that GROW cannabis haven't had the same kinds of restrictions in Canada as they have here.
So they can use banks, and more importantly, they can go public, which is why, when you look at any of the cannabis funds in any country, they're LOADED with small-cap Canadian agriculture.
In the U.S., growers can't readily list, or even use the banks.
So everything is basically private.
On top of that, custodians in the U.S. have been hesitant to hold the shares of the Canadian cannabis growers at all, which has made launching cannabis funds here tricky.
The one we have - MJ - backdoored this by taking an existing fund (LARE) - a Latin American real estate fund - and just changing the index it tracked.
The custodial relationship just kind of came along for the ride.
I suspect there were some heated words about it, but in the end, the fund now has $500 million in assets or so, and the custodian seems to have gotten comfortable with it.
OK, a few more quickies here:


BondMan: For AGG investors, which enhanced AGG product would you suggest, NUAG or AGGY (or something else), and why?
Dave Nadig: So, the AGG has an issue, honestly, in that it was never designed as an investable index.
It just holds too many bonds, for one thing, and also has weird ways of dealing with things like Yankee bonds.
So in that sense, it's an "easy" target to try and beat, whether you're building an index or you're an active manager.
As for the two you mentioned -- this is a place where you really need to dig into holdings.
They both say they're after similar things, but the portfolios look quite different.
In particular, (last I looked), NUAG gets pretty in the weeds on the investment-grade corporates -- big loadings on financials, industrials, etc.
But truly - its very hard to tease either one apart without getting deeply into the weeds
I'd point out the expense differences are real, though.
I think AGGY is 11-12 basis points, and NUAG is something like 20.
That may not sound like a lot, but when we're looking at fixed income, that actually is a meaningful difference.
My advice is not to try and shorthand these funds, but really wade into the individual funds and match it up with whatever other fixed-income exposure you might have.
OK, one or two more here:


Guest: What's with the liquidity rule thing from today's meeting?
Dave Nadig: So, different than the ETF rule discussion, there was another agenda item about the mutual fund liquidity rule (which covers ETFs and mutual funds equally).
A few years ago, they floated a reporting regime that goes into effect next year, which has funds take their holdings and put them in "buckets" of liquidity.
Basically, easy to hard.
The idea was that investors could get some sense of how in trouble they might be in a big market event (like Third Avenue's high-yield fund, when it imploded).
What changed today is the SEC is now saying "nope, you don't have to tell EVERYONE; you only have to tell US."
So it's not public disclosure anymore, it's just SEC reporting.
(Funds will have to make a quarterly verbal statement to investors still, but with no numbers).
The two more left-leaning members of the commission (Stein and Jackson) were not happy about this fairly last-minute change.
It was the most heated part of today's meeting, for sure.
The end result is bad (in my opinion), because i think more data is always beneficial.
Theoretically, after the SEC monitors the data for a while, we might get disclosure, but that's quite literally now years off.

OK, that's going to wrap it up.

Don't forget to check out our weekly podcast with ETF Prime:

And we'll have more coverage of the SEC rule over the next few days.

Thanks everyone, see you next week! Same time, same place.

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