The Securities and Exchange Commission (SEC) is proposing a new rule under the Investment Company Act of 1940 that would permit exchange-traded funds (ETFs) that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order.
The SEC explains that ETFs currently rely on exemptive orders, which permit them to operate as investment companies under the Act, subject to representations and conditions that have evolved over time. “We have granted over 300 of these orders over the last quarter century, resulting in differences in representations and conditions that have led to some variations in the regulatory structure for existing ETFs,” the agency says. The SEC says the proposed rule would level the playing field for ETFs that are organized as open-end funds and pursue the same or similar investment strategies.
Proposed rule 6c–11 would simplify this regulatory framework by eliminating conditions included within the SEC’s exemptive orders that it no longer believes are necessary for its exemptive relief and removing historical distinctions between actively managed and index-based ETFs.
Although the Rule would provide exemptions for both index-based ETFs and actively managed ETFs, it would not establish different requirements based on whether an ETF’s investment objective is to seek returns that correspond to the returns of an index.
The SEC says it believes that index-based and actively managed ETFs that comply with the rule’s conditions function similarly with respect to operational matters, despite different investment objectives or strategies, and do not present significantly different concerns under the provisions of the 1940 Act from which the rule grants relief. The SEC further believes that it would be unreasonable to create a meaningful distinction within the rule between index-based and actively managed ETFs given the evolution of indexes over the last decade, and that eliminating the regulatory distinction between index-based ETFs and actively managed ETFs would help to provide a more consistent and transparent regulatory framework for ETFs organized as open-end funds.
“The fact that the rule treats index funds the same as active funds could be a tailwind for the adoption of active ETFs among all investors including institutions. Often the term ‘ETF’ was synonymous with ‘passive investing’—the proposed rule could help put that misconception to rest,” David Mann, Franklin Templeton’s head of Capital Markets, Global ETFs, tells PLANADVISER.
The rule would only be available to ETFs organized as open-end funds. ETFs organized as unit investment trusts (UITs), ETFs structured as a share class of a multi-class fund, and leveraged or inverse ETFs would not be able to rely on the Rule and instead would continue to operate under their existing exemptive orders.
Providing investors with more information
The SEC also is proposing certain disclosure amendments to Form N–1A and Form N–8B–2 to provide investors who purchase and sell ETF shares on the secondary market with additional information regarding ETF trading costs, regardless of whether such ETFs are structured as registered open-end management investment companies (open-end funds) or UITs.
ETFs must include disclosure that investors may be subject to brokerage and other fees when buying or selling ETF shares.
The rule also includes a new Q&A section that is designed to provide information about bid-ask spreads and other trading costs and uses the following format:
- What information do I need to know about ETF trades?
- What costs are associated with trading shares of an ETF?
- What is the bid-ask spread?
- How does the bid-ask spread impact my return on investment?
- But what if I plan to trade ETF shares frequently?
- Where can I get more trading information for the ETF?
The Q&A must provide links to the fund’s website, including to the newly-required interactive calculator for cost-related information.
According to a 2017 report from Greenwich Associates, institutional assets are flowing into ETFs as U.S. institutions, including defined benefit (DB) plans, integrate them into essential investment functions ranging from risk management and liquidity enhancement to the generation of income and yield in a challenging interest-rate environment.
“ETFs help institutions to hedge risk, manage their cash flow needs, gain quick exposures to illiquid market segments, and more. But in order for institutional use of ETFs to grow and mature, long-held structures for managing clients and trading products need to change,” concludes a report written by Greenwich Associates Managing Director Kevin McPartland, who is head of research for the firm’s Market Structure and Technology practice. Investors and broker-dealers should start treating ETFs as an asset class all their own, McPartland says.More about the SEC’s proposals and thinking can be viewed in the 80-page filing with the Federal Register. The SEC is asking for comments on the proposals by October 1.