Until now, investment advisers seeking to launch ETFs had to navigate a costly and time-consuming approval process. The long-awaited change should be a boon to investors and managers alike, but it will also mean adapting to the new framework and keeping an eye on expiring exemptions.
Since ETFs were first developed over 27 years ago, they have increasingly gained popularity. From $531 billion held in 2008, ETFs crossed the $4 trillion milestone in July 2019. Although mutual funds remain the most popular option with retail investors, with total global net assets of mutual funds registered in the United States amounting to approximately $17.71 trillion in 2018, ETFs are undoubtedly chipping away at mutual funds’ market share.
Regulators have monitored this area closely. According to SEC Chairman Jay Clayton, “ETFs … have provided investors with a number of benefits, including access to a wide array of investment strategies, in many cases at a low cost.” As the ETF industry is continuing to grow in “size and importance, particularly to Main Street investors,” the regulator has consolidated regulation in this area through the rule-making process. The new Rule 6c-11 (the New Rule) attempts to establish a consistent framework for the launch and operation of most ETFs, in order to facilitate competition, lower entry barriers and remove the need for individual ETF exemptive relief applications.
Daily disclosure obligations combined with ‘custom basket’ provisions
Consistent generally with conditions in prior ETF exemptive orders, the New Rule imposes conditions on ETFs, including:
- Website disclosure/transparency: An ETF will be required to provide daily portfolio disclosures on its website, such as its portfolio holdings, net asset value, market price, premium or discount, the extent and frequency of those premiums and discounts, and median bid-ask spread over the past 30 calendar days. These disclosures are intended to provide investors with information about the costs of investing in ETFs and the efficiency of ETFs’ arbitrage processes.
- Custom basket policies and procedures: An ETF will be permitted to use a representative basket that does not reflect a pro rata share of the ETF’s entire portfolio or that differs from the initial basket used in transactions on the same business day (“custom baskets”) if the ETF adopts written policies and procedures that “(i) set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders and (ii) specify the titles or roles of the employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters.” ETFs will also have to comply with certain record-keeping requirements, including information regarding each basket exchanged with an authorized market participant.
Rescinding many existing exemptions, but not all of them
In order to create a consistent and harmonized ETF regulatory framework, the SEC will rescind the portions of prior ETF exemptive orders that granted relief related to the formation and operation of an ETF, including certain master-feeder relief, one year after the New Rule’s effective date. However, the SEC decided to grandfather certain existing master-feeder arrangements involving ETF feeder funds in lieu of the formation of new ones, by amending relevant exemptive orders. The SEC will not rescind exemptive orders that permit ETF fund of funds arrangements. Moreover, ETFs relying on the New Rule that do not already have their own exemptive relief will be able to enter into fund of funds arrangements as set forth in recent ETF exemptive orders, provided that they satisfy the terms and conditions for fund of funds relief in those orders, until the SEC issues a rule specifically governing fund of funds arrangements. If you have received an ETF exemptive order or have filed an application for such an order, you should consult with counsel as to the effect the New Rule will have on the relief you are relying on, and the availability of fund of funds and master-feeder arrangements.
The New Rule will be available only to ETFs organized as open-end funds. Leveraged or inverse ETFs and those organized as unit investment trusts (UITs); ETFs structured as a share class of a multiclass fund; and nontransparent ETFs will not be able to rely on the New Rule.
In addition to the New Rule and conforming form amendments, the SEC issued an exemptive order that harmonizes certain related relief under the Securities Exchange Act of 1934, as amended (the Exchange Act). The exemptive order provides relief to broker-dealers and other persons engaging in certain transactions in securities of ETFs from certain requirements under the Exchange Act with respect to ETFs relying on the New Rule.
The rule, form amendments and related exemptive relief have been published on the SEC’s website and will be published in the Federal Register as well. They all will become effective 60 days after publication in the Federal Register.
The final rule is available here.
The exemptive order is available here.