The Securities and Exchange Commission adopted a long-awaited exemptive rule that will allow most exchange-traded funds (ETFs) to operate without an exemptive order, subject to various conditions. The final rule, which the SEC approved at a closed-door meeting on September 25, 2019, also rescinds certain orders that the SEC previously issued to ETFs and their sponsors.
Rule 6c-11 under the Investment Company Act of 1940, as amended (the 1940 Act) becomes effective 30 days after publication in the Federal Register. The rule allows ETFs to use “custom baskets,” subject to certain conditions, which we summarize below. Geared, or leveraged, ETFs and inverse ETFs cannot rely on the rule.
Among other things, the rule requires an ETF:
- To disclose portfolio holdings in a standardized format each business day on its website before trading on the ETF’s primary listing exchange opens. An ETF also must disclose on its website its NAV, market price, premium or discount amounts, and the extent and frequency of them.
- To disclose the median bid-ask spread over the last 30 calendar days on a rolling basis.
- To adopt and implement written policies and procedures that govern the construction of baskets and the process used to accept baskets, including custom baskets.
Custom baskets. The rule allows ETFs to use custom baskets if its basket policies and procedures:
- Include detailed parameters for constructing and accepting custom baskets that are in the best interest of the ETF and its shareholders, including the process for any revisions to, or deviations from those parameters; and
- 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
Custom baskets will provide ETFs with flexibility to define creation and redemption units. The SEC rationalized that this feature would benefit investors through more efficient arbitrage and narrower bid-ask spreads, subject to certain protections.
Exclusions. The SEC excluded certain ETFs from relying on the rule. These include ETFs structured as Unit Investment Trusts, leveraged/inverse ETFs, share class ETFs and non-transparent ETFs, which means that they must continue to apply for and obtain exemptive orders to operate. For all other ETFs, the rule rescinds existing rules, with one notable exception: The SEC did not rescind portions of prior ETF exemptive orders that allow funds to invest in ETFs in excess of the statutory limits (anti-pyramiding rules); the rule prospectively allows new ETFs to enter into certain fund of funds arrangements.
Disclosures. Rule 6c-11 and amendments to Forms N-1A and N-8B-2 eliminate certain disclosure requirements.
- Among other things, ETFs must provide median bid-ask spread information either on its website or in its prospectus. This disclosure is designed to inform investors that they may bear bid-ask spread costs when trading ETFs on the secondary market. The SEC tweaked its original proposal to require ETFs to use the standardized National Best Bid and Offer (NBBO) for computing the bid-ask spread to make the computation uniform. In response to comments received on the original proposal, the SEC dropped the proposal that would have required ETFs to disclose examples illustrating how bid-ask spreads would affect the return on a hypothetical investment for both buy-and-hold and frequent traders, and an interactive calculator in a clear and prominent format on the ETF’s website that would allow investors to customize hypothetical bid-ask spread calculations.
- To the relief of many ETFs, the SEC did not include a requirement for ETFs to disseminate intraday indicative value (IIV), because, among other reasons offered, the IIV is not necessary to support the arbitrage mechanism for ETFs that provide daily portfolio holdings disclosure. This change likely will result in savings for ETFs and investors.
- The rule does not include a requirement that an ETF disclose its portfolio holdings before it starts accepting orders for the purchase or redemption of creation units, as originally proposed. Rather, the rule will require an ETF to disclose the portfolio holdings that will form the basis for the ETF’s next calculation of NAV per share each business day before the opening of regular trading on the primary listing exchange of the ETF’s shares.
- The rule will also eliminate a requirement that an ETF disclose in its prospectus that it does not sell or redeem individual shares and explain that investors may purchase or sell ETF shares through a broker or on a national securities exchange. By eliminating this requirement, the SEC has acknowledged that the ETF market has matured and that the investing public is no longer likely to confuse an ETF with a mutual fund.
Our take. Overall, the long-awaited rule is a welcome addition to the rules under the 1940 Act. It will remove some time and cost barriers for new garden-variety ETFs that want to enter the market, and will eliminate some disclosure hoops that many feared the SEC would impose. Geared ETFs and non-transparent ETFs, however, are precluded from relying on the rule. The SEC, it seems, may consider those on another day.