After more than a decade in the making, the U.S. Securities and Exchange Commission (SEC) finally implemented the new “ETF Rule1” – leaving the ETF industry, well, essentially the same as it was before.
The ETF Rule was designed to modernize the regulatory scheme for ETFs without propelling product growth or innovation, but that doesn’t mean its impact will go unnoticed. One of the new rule’s subtle developments is slowly forcing the industry to reconsider what it means to be an “index” ETF. For more than two decades, index ETFs have been defined by their investment objectives and a condition of their exemptive orders that typically required investing at least 80% of their assets in the constituents of their underlying index. That 80% policy is nowhere to be found in the ETF Rule – nor is any related requirement regarding correlation with the fund’s index.
The soon-to-be-retired regime of exemptive orders drew a distinct line between index ETFs and actively managed ETFs – largely because issuers had to obtain separate exemptive orders for the two groups. Now, the new rule no longer requires an ETF to fit squarely into one of those camps. Consequently, the ETF Rule opens the door for existing and future ETF issuers to redefine passive and active investing. While most index ETFs today invest nearly all their assets in their underlying index, the new rule could pave the way for a different approach: ETFs that seek to combine elements of index-based investing with actively managed strategies in a hybrid structure. Time will tell if the ETF marketplace decides to stick with the historic definitions or welcome more innovative ideas.
Similarly, some existing index ETF issuers may seek to drop the formalities of publishing and tracking an index now that the potential tax advantages have essentially been negated. Such a move raises the question of whether investors will view ETFs with objective, quantitative-based strategies as “passive” products in the absence of a formal index.
Additionally, the ETF Rule may have inadvertently rendered itself obsolete by ignoring the emergence of so-called “non-transparent” ETFs. This niche of products that don’t disclose all their holdings daily – breaking a nearly 30-year ETF hallmark – has the potential to draw investment advisors that have been unwilling to enter the ETF space due to concerns about front-running and copycat products from the sidelines. While there’s no shortage of non-transparent models proposed to the SEC, each requires a unique exemptive order.
Investors’ interest in non-transparent products remains unclear. Attention to these products is further fueled by speculation that the industry will soon see a mutual fund-to-ETF conversion. If such a conversion occurs, it’s possible 2020 will be the next inflection point for growth in the number of ETF products and assets, whatever their design may be.
Michael Barolsky, Esq., is part of the Regulatory Administration team. He provides legal assistance, primarily with respect to the registration and regulation of exchange-traded funds and mutual funds. Michael received his Juris Doctor from the George Washington University Law School.