The New Norm to Launching ETFs

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The New Norm to Launching ETFs

July 2018

By Jeffrey McCarthy

Ten years following the first proposal by the SEC for an ETF rule, the ETF industry may finally be set to receive its own rule under the Investment Company Act of 1940 (“40 Act”). 

Since being proposed in 2008, the ETF industry has seen the number of ETFs grow from 704 to 1,8891 as of May 2018 and AUM grow 569%, eclipsing $3.4 trillion2 this past May.

 

On June 28th, the SEC’s division of Investment Management (“IM”) in cooperation with Trading and Markets published to the federal register rule 6c-11 (the “ETF rule”). The rule seeks to provide an easy entry point for asset managers to launch an ETF that is focused on non-levered actively managed transparent or index based strategies structured as an open-end fund without the need for exemptions from the 40 Act — a process that can add months to a product launch timeline.

 

In their proposal the SEC has focused on a number of areas, including:

  1. Custom Baskets: Custom baskets will be eligible for all ETF issuers relying on rule 6c-1. In conjunction with this capability, asset managers will be required to maintain policies and procedures on how custom baskets will be constructed, utilized and must also specify the titles or roles of the employees that form the list of approvers at the investment advisor. The advisor will be required to maintain records of all custom baskets for a minimum of 5 years inclusive of the participant that was party to the custom order.
     

The expansion of custom baskets to all ETF issuers in the U.S. is a welcome step for the industry because it helps to equalize the playing field. This is a key component for ETFs looking to maximize their tax efficiency through in-kind deliveries, while also seeking to reduce the total cost of ownership for shareholders. Portfolio managers would now be able to negotiate with firms that may not have an exact replica of a fund’s holdings, leverage the tax efficiency for rebalances, and potentially reduce costs to investors thereby make it easier to optimize what moves in and out of the ETF.
 

2. Website Disclosure:

  • ETFs will be required to publish the portfolio holdings that forms the basis of the calculation of the NAV per share.
  • ETFs will be required to publish the ETFs basket applicable to creation or redemption activity for that trading day for market open including any custom baskets that are approved.
  • ETFs will be required among other things to publish the ETF’s NAV, market price or official closing price (“OCP”), its current and historical premium/discount, and its bid/ask spreads.
     

BNY Mellon believes that standardizing the disclosure requirements for an ETF's website will likely assist end-users of ETFs to run a like-for-like comparison and builds on the transparency that ETFs are known for. As ETFs continue to see an increase in use, the ability for customers to have a standard data set to analyze an ETF will be welcomed. That said, the push towards having a custom basket disclosed before market trading will be a significant change to today’s operating model (that may not provide as much benefit for end users). The increased monitoring and data dissemination may have a larger impact on newer ETF issuers with a more limited benefit for their shareholders.
 

3. Regulatory Filing Amendments: New disclosures will be required on Form N-1A for open-end ETFs, and Form N-8B-2 for unit investment trusts (“UITs”). These new disclosures focus among other things on trading costs such as the bid/ask spread and premium/discount to NAV. Amendments would also be made to Form N-CEN.
 

Given the difference in how an ETF is bought and sold by individuals versus mutual funds, the ability to have insight into a total cost of ownership, such as trading and management fees may be helpful for investors to understand what they are acquiring. The addition of these disclosures to a ETFs N-1A or UIT’s N-8B-2 outweigh the incremental costs that may be incurred. We note that many of these disclosures are already captured today, by the ETF’s administrator or its portfolio manager. As such, these new disclosures are not a radical departure from the regulatory reporting process that exists today for ETFs.
 

Further to these three areas, the SEC is proposing to level the playing field for ETF issuers by rescinding certain exemptive relief previously granted. This includes:

  • Removal of any exemptions to support master-feeders for an ETF (if not relying on the relief today); and
  • ETFs will no longer be required to maintain the dissemination of an Intraday indicative value (“IIV”) as a condition of the ETF rule, however this will still be applicable as part of the listing exchange’s rule (i.e., NYSE Arca Equities Rule 5.2-E(j)(3)).
     

Throughout its history of servicing ETFs, BNY Mellon has built leading capabilities that provides support for the negotiation of custom baskets, website publication of key data points and ETF-specific financial reporting guidelines.
 

While there are many questions that the SEC has posed to the public for commentary, we are excited to see the SEC take this step towards a consistent regulatory framework for the majority of ETFs and hope it will make launching new products, easier, quicker and cheaper.
 

Access to the SEC’s proposal can be found here: https://www.sec.gov/rules/proposed/2018/33-10515.pdf
 

The comment period for the proposal will be available for sixty (60) days before the next action is taken by the SEC.
 

For more information on how the ETF rule may affect your operational model and product strategy, visit BNY Mellon ETF Services.

Jeffrey McCarthy

Global Head of Exchange Traded Funds, BNY Mellon Asset Servicing

1 “Monthly Exchange Traded Fund Data” (May 2018). ICI.org

Industry insights – May 2018. ETFGI.com

 


 

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