The SEC has announced that it will “consider whether to propose rule 6c-11 under the Investment Company Act of 1940” at its next open meeting, which is scheduled for June 28. The rule has been floating around for at least a decade but has never made past the stage of consideration.
One of the most important features in the eyes of many is that it would basically allow would-be ETF issuers to skip the exemptive relief application currently required to launch ETFs. Essentially it would codify the exemptions from the 1940 Act that issuers are currently required to have to roll out their own ETFs.
The rules would apply to passive funds and transparent active funds. This would be basically a rubber stamp allowing issuers to skip a step and potentially reduce costs for them, not to mention shrink the timeline to a launch.
Big Deal Or Not?
On one level it’s pretty interesting and—if you’re a certain kind of ETF nerd—exciting. According to ETF.com Managing Director Dave Nadig, the industry has essentially been waiting for an ETF rule since the launch of SPY back in 1993.
“ETFs have been governed by exception, not by a proactive rule saying ‘here’s what you’re allowed to do,’” said Phil Bak, CEO of Exponential ETFs.
“We’re talking about a rule that was written in 1940. It’s 2018,” he continued. “We’re seeing some real innovation in the ETF space, things that could never have been contemplated back in 1940. It’s long past time that we see a rule addressing the market vision of the markets and the fact that ETFs are the vehicle of choice for the modern investor now.”
Uneven Playing Field
Perhaps because it’s largely ruled by exceptions, the ETF field is an uneven one. The SEC can change its mind about investment concepts as time passes and depending on who is in charge or public reactions. For example, while firms like ProShares and Direxion are approved to launch a wide range of leveraged and inverse products, the regulatory agency has cracked down on the leveraged/inverse concept after a wave of investor lawsuits.
That makes for a lot of business uncertainty and an anticompetitive, nonlevel playing field, Bak notes.
But nobody knows what exactly will be in the rule should it be proposed, or how far it will go in its final version.
“The reality is I don’t think anyone actually knows what’s going to go down,” said Alpha Architect CEO Wes Gray. “People have been talking about this for who knows how long. I still feel like there may be a ‘boy who cried wolf component’ here.”
The meeting on Thursday, June 28 will involve considering whether to simply propose the rule. Once the rule is proposed, it would normally undergo a comment period that could lead to changes in the final version. Basically, the situation is full of all kinds of potential outcomes, but it’s hard to predict what will actually happen.
Interestingly, this rule change has become less important as the ETF industry has matured. Bak points out that while applying for exemptive relief for ETFs originally involved a sum potentially exceeding $1 million and taking a year for final SEC approval, the time and expense have shrunk to less than $20K for the filing of the 40-APP and a few months’ wait for the SEC’s blessing.
Threat To White Label Issuers
While the benefit to most issuers and ETF shareholders could be incremental, the removal of the need for exemptive relief could be a real blow for white-label ETF issuers. Exemptive relief is just one of the services they provide, but it’s a key feature. They use their expertise to navigate the administrative and regulatory headaches many would-be ETF providers don’t want to deal with.
“Historically a lot of the value that white label [ETF issuers] have provided is in having that exemptive relief that can be utilized by their partners. So if that is taken off the table, I think it’s going to be imperative for white-label sponsors to find other ways to add value,” Back said, such as distribution and general consulting. In particular, he points out that helping ETF providers find liquidity providers and market makers is a particularly important service.
According to Gray, the streamlining of the approval process is just the easing of a minor annoyance for small issuers.
“That’s not the barrier to entry to the ETF business. If they streamline that, that’s cool—it’ll be nice to save [$15,000] the next time around,” he said. “But that’s not a big deal, honestly. I think that component will go through.”
“Really the barrier for a startup is how you’re going to tell the market about your stuff. It’s not really the legal barriers that are the problem,” Gray pointed out. “I think the message that this is somehow going to be a windfall for entrepreneurs is a false narrative.”
For Gray, the issue of real interest is what the rule would mean for the creation/redemption process, which lies at the heart of ETFs’ tax efficiency.
Early on, the SEC allowed exemptions for custom creation/redemption baskets for passive as well as active funds, meaning funds could, for example, give authorized participants Microsoft if they were redeeming, but demand they deliver Oracle if they were doing a creation.
This allows them to use the creation/redemption process to make changes in overall portfolio composition, or even work with an AP to help a client put on a large trade by taking a large basket of securities they have on hand that don’t exactly match the funds’ portfolio.
“Custom creation/redemption baskets are the largest unlevel playing field in the ETF industry,” ETF.com’s Nadig noted. “It doesn’t keep a new player from being in the market, but it can make a difference when a fund gets large enough to attract institutional attention, or large enough to have an impact on the securities it holds.”
The haves/have-nots was created when, in 2012, the SEC put a hard stop on issuing exemptive relief that included custom baskets—precisely when a new wave of higher-turnover actively managed products started coming to market. This hurt the ability of many new entrants to be active while maintaining the tax efficiency of an index-based approach.
Of course, as with all regulatory issues, there is no telling what actually comes out of the meeting next week, but for ETF nerds, it’s a rare “grab the popcorn” moment. Literally. The June 28 meeting will stream live from D.C. at 10 a.m. from the SEC’s website.
Contact Heather Bell at [email protected]