SEC Passes Landmark ‘ETF Rule’

September 26, 2019

3:10 PM: Updated to include more information about exempted ETFs.

1:40 PM: Updated to include additional clarity about custom creation/redemption baskets, as well as comment from John McGuire.

12:00 PM: Updated to include more information about master-feeder ETFs.

The SEC announced this morning that it would adopt Rule 6c-11, otherwise known as the "ETF Rule," after canceling a meeting intended to vote on the rule on Wednesday.

The ETF Rule, which has been in the works for the better part of a decade, updates the framework governing how ETFs are brought to market and regulated. Not only does the regulation tighten transparency and disclosure requirements, it eliminates the costly, time-consuming "exemptive relief" requirement.

 “As the ETF industry continues to grow in size and importance, particularly to Main Street investors, it is important to have a consistent, transparent, and efficient regulatory framework that eliminates regulatory hurdles while maintaining appropriate investor protections," said SEC Chairman Jay Clayton in the press release.

No More Exemptive Relief Needed

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").

This process, which issuers had to undertake before launching any ETFs, cost tens or even hundreds of thousands of dollars (though the expense had come down in recent years). It also introduced a delay to new launches of anywhere from three to six months.

Since 1992, the SEC has issued more than 300 exemptive orders, the press release stated.

What's more, each of these orders was individually and inconsistently granted, leading to an unlevel playing field where the relief given to older issuers was often more permissive than that given to newer ones (read: "SEC Backs Major ETF Rule Change").

The new ETF Rule will replace the existing system of hundreds of individualized orders with a single, applicable rule.

More Transparency & Disclosure

The ETF Rule also requires issuers to publish certain investor-friendly disclosures, including daily portfolio holdings on their websites—something many issuers already do—as well as historical information regarding premiums and discounts and bid/ask spreads.

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.

"I think the approach the SEC took toward custom baskets [by requiring written policies and procedures] was very reasonable," said John McGuire, partner at Morgan, Lewis & Bockus LLP and former staff member of the SEC's Investment Management Division. "Everybody realized this was an unlevel playing field. So that's all we were hoping for: a recognition that there are fiduciary duties people have to ensure these things are done in the right way."

Rescinds Previous Orders

The ETF Rule and its various amendments go into effect 60 days after their publication in the Federal Register, though a one-year transition period will be allotted for issuers to get full compliance.

One year after the effective date, the SEC will rescind exemptive relief orders previously granted to ETFs that would otherwise be able to launch using the rule.

The SEC will also rescind permission for master-feeder ETFs, though a few select funds will be grandfathered in. (Fund-of-fund ETFs, however, are safe.)

More commonly used by hedge funds, the master-feeder structure is one in which one or more 'feeder' ETFs accrue investor capital, then use those assets to purchase shares of a 'master fund', which holds and trades the actual investment portfolio. This gives the master fund the flexibility to, for example, serve both domestic and foreign investors at the same time.

Master-feeder ETFs never took off with investors, however, and few ETFs now use the structure.

Rule Doesn't Universally Apply

Notably, the ETF Rule doesn't apply to all ETFs. Exempt from the rule are unit investment trusts, a mostly extinct class of ETF, save for a few notable exceptions, like the SPDR S&P 500 ETF Trust (SPY). Nor does the rule apply to leveraged or inverse ETFs, or ETFs structured as a share class of a multiclass fund (aka, the Vanguard model).

"That's a remarkably large amount of the industry by assets," added McGuire. The exempted funds total roughly $1.5 trillion in assets, or about 37% of all assets invested in ETFs. Vanguard ETFs alone account for $1.1 trillion.

Furthermore, the ETF Rule won't apply to the nontransparent active ETF structures that conceal some or all of their portfolio holdings from investors.

Any new entrant of the exempted types of funds would still need to seek individualized approval from the SEC.

Still, said McGuire, "I think the SEC did a good job. I think the commission got it."

Speaking of the ETF Rule on his Twitter account, ETF.com Managing Director Dave Nadig wrote, "It's a win for investors and the industry. That's a rare and good thing."

Contact Lara Crigger at [email protected]

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