ETF NAVs: Looking under the hood
April 11, 2018ETF NAVs: Looking under the hood
Last week, the SEC published for comment a proposed rule which would harmonize the regulatory requirements imposed on most ETFs in the U.S. market. We explain what is on the table.
The U.S. ETF market kicked into existence with the launch of SPY in 1992. In the ensuing 26 years, every ETF launched in the U.S. has relied on exemptions granted under the Investment Company Act of 1940 (often known as the “40 Act”) to permit a structure as an open-ended investment company, or alternatively a unit investment trust (“UIT”). These exemptions have become commonplace and routine; the SEC filing claims that over 300 have been issued thus far. For a detailed list of exemptions, please refer to the SEC’s 2015 request for comments on ETFs.
The reliance on exemptions for each fund filing leads to an environment where the rules imposed on funds launched at different times may differ, as well as the added time and expense of seeking exemptive relief. The SEC’s proposed rule 6c-11 (under the 40 Act) seeks to address this problem by harmonizing requirements for all ETFs structured as open-ended investment companies.
Notably, the distinction between open-ended funds and UITs – which is substantially a matter of fund governance – means that many of the oldest and most established products are actually not covered by the proposed rule. This list includes the SPY and QQQ. This distinction is largely a red herring, as the UIT structure has largely fallen out of favour for a variety of reasons.
The proposed rule draws no specific distinction between active and index-tracking ETFs, in recognition of the blurred line between an “active” ETF and one which tracks an index that is constructed to replicate the same active strategy, and is only used by the ETF using it as a benchmark. We commend the decision to treat like as like, and ease the stranglehold custom index providers sometimes exert on the basis of favoured regulatory treatment for “index” funds which are nonetheless index-tracking in name only. However, the line is drawn at leveraged and inverse ETFs: they are specifically excluded and would continue to need to apply for fund-by-fund exemptive relief. Note: exchange traded notes (ETN) are yet another legal structure, and also not in scope.
The proposed rule 6c-11 is a request for comments and isn’t final. The last such rule proposal occurred in 2008 (proposed rule, comments), and did not result in a permanent rule change. Since that time, the SEC published a request for comments in 2015 (RFQ, comments) to update SEC staff on industry views on a comprehensive range of ETF-related issues. There is no certainty that the rule will be adopted in its current form, and we expect U.S. industry to weigh in on several of the more contentious issues as part of the comment process.
The substance of the proposed rule is to define the criteria that must be met for an ETF structure to be deemed compliant with the 40 Act.
1. The rule would require that Authorized Participants (“APs” – those firms allowed to create & redeem blocks of ETFs) be members of a clearing agency, i.e. DTC. This codifies the requirement that to be an AP in the U.S. market, the firm must be self-clearing. Notably, this technical requirement does not prevent firms who are not directly AP’s (due to lack of self-clearing) from outsourcing the creation & redemption activities to another dealer. This practice is prevalent in the U.S., and also exists in Canada to an extent.
2. ETFs need to be, unsurprisingly, exchange-listed. The rule does not permit ETFs to be traded OTC.
3. The proposed rule does not require the publication of intraday indicated values (“IIVs”), which are intraday (every 15 second) snapshots of the theoretical NAV of an ETF at that time. This is a commonplace feature of the U.S. market, is part of listing requirements, and in the past has been part of the exemptive relief granted to ETFs. We believe IIVs are far less useful than initially contemplated, as the products where IIVs are valuable are where the underlying assets are opaque, or their markets are closed. In those circumstances, the IIV’s third party calculation agent would typically have no ability to accurately price the IIV anyway. As a result, IIVs lead to widespread confusion. We wholeheartedly agree with the removal of the IIV requirement from the proposed rule, and support the Canadian practice of not publishing them either.
4. The rule stipulates that all ETFs must provide a disclosure of portfolio holdings on the website, prior to the opening of trading and free of charge. The requirement also stipulates that the portfolio disclosure must be actual holdings, and not a sample, proxy, or risk factor disclosure. This requirement effectively shuts the door on non-transparent ETF proposals, such as those pursued by Percidian Investments, T. Rowe Price and others.
5. Require a greater degree of control (by way of policy and procedure requirements) on the manner in which custom creation and redemption baskets are constructed. This may seem a technical matter, and substantially it is. However, it is noteworthy that the majority of creation & redemption activity in U.S. fixed income ETFs takes place through custom basket negotiations. Additionally, custom redemptions are frequently used by ETF issuers in connection to the disposition of holdings around index events. A tightening of controls over this process can have an indirect impact on many players in the industry.
Fog at the 49 parallel
The most significant component of the SEC’s proposed rule 6c-11 lies in the details of the transparency requirements imposed on ETFs. The proposed rule would mandate that each fund’s complete holdings, including all securities, derivatives, short positions, cash holdings, etc., be made publicly available in a standardized format, each day. Further, the disclosure on trade date T must be the holdings as of the prior day’s end, and must also be the portfolio that determines the fund’s NAV at the end of T.
This combination of factors has two significant consequences:
1. Because the portfolio being disclosed must determine a fund’s NAV on T, any trades occurring on T, which result in profits & losses, will not be booked into the fund until the subsequent day, T+1 .This has the effect that a holder on T can redeem their units and avoid a potential loss, while someone subscribing on T would be transferred that loss in the T+1 NAV and have no way of avoiding it.
2. The ability of active managers to launch non-transparent ETFs is effectively shut down going forward (subject to exemptive relief applications, of course). Note that this is not surprising: the SEC has rejected all active non-transparent applications to date, including various creative structures involving blind trusts and intraday indicative values.
While we philosophically agree with the merits of transparency in the ETF market, we note that in both respects this proposal is a marked departure from Canadian norms.
First, the majority of funds in Canada operate on the basis that trades are reflected in the fund on trade date. This is the fairest and most consistent practice, though there are exceptions within the Canadian market to this also. We would respectfully suggest that codifying the T+1 treatment in a rule focused on transparency of holdings does not accomplish any incremental benefit. This wrinkle is easily solved by tweaking the requirements slightly and allowing fund manufacturers to adopt a more timely NAV methodology.
Second, Canadian daily transparency requirements are not specifically described in regulation, but rather are a matter of industry practice combined with limited guidance from the OSC. Canadian securities law and regulation requires semi-annual disclosure of holdings by all funds (including ETFs), while the OSC’s note on the subject (Investment Funds Practitioner, December 2016) acknowledges the existence of ETF structures with limited disclosure of portfolio holdings to the dealer community only. The lack of further guidance on this point appears to condone the status quo. This means that Canada permits active non-transparent ETFs while the U.S. does not. In fact, Canada features a range of products where transparency is only offered to a small number of dealers. In one circumstance, an ETF issuer in Canada operates products with no daily disclosure at all.
The SEC’s stance on transparency appears to be rooted in a desire to ensure that the market prices of ETFs properly reflect the underlying portfolio value by fostering an effective arbitrage mechanism. This goal is certainly laudable. It appears that on this file, the SEC has taken a much stricter interpretation of what is required to ensure arbitrage than Canadian regulators. In the process, we believe the SEC has also drawn a line in the sand on the types of products which could reasonably be expected to be featured in the ETF market, as issues around information leakage and intellectual property are likely to trump active managers’ desire to launch an ETF product which is similar to existing mutual fund offerings.
Overall, the SEC filing reflects a deep and nuanced understanding of the ETF market, with clear rationale for many of the decisions made in the formulation of proposed rule 6c-11. This understanding is likely underpinned by the numerous thoughtful responses to the 2015 request for comments, which would have informed the current rule proposal.
In fact, we believe the major point of contention for industry will be related to the SEC’s hard line on portfolio disclosure. Active managers looking to gather assets through an ETF structure would find little to cheer. However, this is not a panacea for the index provider community, either: the lack of distinction between index-tracking and non-index funds will reduce the ability of index providers to sell the idea of a “custom benchmark” as an easier path to launching an ETF. In our view, this is also a healthy development, as the modern index business has little in common with the theoretical underpinnings of indexing in portfolio theory.
We look forward to seeing the comment process unfold on this important proposal.
For questions or more expert ETF insights, please contact:
Director, Head of ETF Trading
Director, ETF Trading
Managing Director, Head of Portfolio Trading