New Framework For ETFs-Of-ETFs

On Oct. 7, the Securities and Exchange Commission (SEC) voted to update its regulatory framework governing funds-of-funds, including ETFs that hold shares of other ETFs.

First proposed in December 2018, this new rule formalizes the process of how registered investment companies and business development companies (BDCs) may buy shares of other funds and BDCs, while also making it easier for them to do so without running into position caps.

“Main Street investors have increasingly used mutual funds, exchange-traded funds (ETFs) and other types of funds to access our markets and invest for their future,” said SEC Chairman Jay Clayton in the press release announcing the changes. "To achieve asset allocation, diversification and other objectives, many funds have also invested in other funds. Today’s action will enhance and modernize the regulatory framework for these arrangements."

Big Money In Funds-Of-Funds

The SEC estimates that roughly 40% of all registered investment funds are invested in the shares of at least one other fund.

That translates to significant assets, especially in the mutual fund space: As of 2019, $2.5 trillion was invested in mutual funds that invested primarily in the shares of other mutual funds.

ETFs-of-ETFs are less common, but they're becoming more widespread. According to FactSet data, there are now 74 pure ETFs-of-ETFs, holding some $12.8 billion in assets under management (though many more ETFs hold shares of at least one other fund, without this arrangement being the primary investment strategy).

Of those 74 ETFs, 21—or 28%—have launched in the past 12 months.

Existing Limits On Funds Holding Other Funds

Until the SEC’s latest rule, however, the ’40 Act restricted how much a given fund could own of another, preventing funds from:

• Buying more than 3% of another fund's voting shares
• Investing more than 5% of net assets in a single fund
• Investing more than 10% of assets altogether in the shares of other funds

Over the years, however, the SEC has granted a number of exemptive relief orders from these limits—paving the way, among other things, for asset allocation ETFs, which generally hold only a handful of other ETFs.

Much as was the case before the ETF Rule, these various exemptive relief orders have created an uneven playing field, allowing some funds more leniency than others. (Read: “SEC Passes Landmark ‘ETF Rule.’”)

With this latest action, Rule 12d1-4, the SEC is making the rules one-size-fits-most, allowing funds to invest in other funds beyond what the ’40 Act allows, so long as certain investor protections are met.

In addition, most previously granted exemptive reliefs will be rescinded and replaced with the new rule (just as it was when the ETF Rule was adopted).

No Controlling Interest Allowed

What are those investor protections? Mostly, they concern the “acquired” fund that's being invested in by another fund, rather than the end retail or institutional investor who might be holding the “acquiring” fund's shares.

For example, acquiring funds won't be allowed to hold a controlling interest in a fund—meaning, they won't be allowed to exert substantive influence on executive management or company policy of the fund they're investing in.

If a fund does hold a controlling stake of another fund's voting shares, then they must vote those shares via "mirror voting," or in proportion to how other investors have voted their shares. (So if 90% of investors vote their shares in favor of a proposal, and 10% against, the acquiring fund must vote the same way.) That's to prevent, say, a bigger ETF from investing a controlling stake in a smaller ETF, then installing their own representatives on their boards.

The SEC defines “controlling stake” here as 25% or more of the voting shares for an open-end fund or unit investment trust, and 10% or more for a closed-end fund.

There are a few exceptions, including when the acquiring fund is part of the same fund group as the acquirer. This makes sense—it's hard to imagine a situation in which an iShares ETF buying other iShares ETFs ought to be prevented from having a say.

Controversial Redemption Limit Struck

To additionally prevent acquiring funds from exerting “undue influence” over the funds they buy—and, equally important, to prevent duplicative charging of fees—the new SEC rule will require both sides of the transaction to do some homework.

Certain "evaluations and findings" must be done before one fund can buy another. Furthermore, funds with different investment advisors must sign a formal fund-of-fund agreement, including provisions necessary to ensure that end-investors aren't being double-charged.

These agreements are nothing new. ETFs and mutual funds that have relied on the exemptive relief orders have been signing them for years.

But it comes as a welcome change from the original proposal, which would have prohibited an acquiring fund that buys up more than 3% of another fund's outstanding shares from placing a redemption order for more than 3% of those shares in any given 30-day period.

The idea behind the redemption limit was to prevent acquiring funds from exerting too much influence over the funds they purchased. However, commenters protested, citing operational challenges and concerns about reduced liquidity and flexibility to respond to market crises.

Allowing For A ‘10% Bucket’

The rule adds a few other stipulations, including updated disclosure requirements on the Form N-CEN filings and the prohibition of three-tiered structures—in other words, an ETF-of-ETFs can't hold ETFs-of-ETFs, except in limited cases.

One of those cases is within a "10% bucket," where the acquired fund is allowed to invest up to 10% of its total investment assets as it sees fit.

Within that 10% bucket, the acquiring fund can basically hold whatever they like, and for whatever purpose.

Next Steps

Now that the rule has been voted on, it will be published in the Federal Register, then become effective 60 days later.

However, previously issued exemptive relief orders won't be rescinded for another 12 months, while compliance for some of the paperwork aspects of the rule won't be enforced until 425 days after the rule was initially published in the Register.

Contact Lara Crigger at [email protected]