The time is now for the Securities and Exchange Commission (SEC) to consider streamlining the exchange-traded fund (ETF) approval process to provide more flexibility for innovation.
ETFs — pools of securities with shares that are listed and traded on an exchange like stocks — have proliferated in number and attracted assets at a dramatic pace over the past few years, reaching $2.56 trillion in the U.S. at the end of 2016.
However, the approval process for new entrants remains slow and inflexible. Active managers, which try to beat the market through security selection, have been effectively hampered from launching ETFs.
Currently, a new ETF sponsor must obtain individualized approval, known as exemptive relief, from the SEC prior to launching its first ETF. The process to obtain this relief can take several months.
Moreover, because applicable SEC standards and requirements have become more stringent over the past 10 years, certain ETF sponsors are subject to more onerous operational restrictions than others, putting them at a competitive disadvantage.
The SEC staff is currently contemplating an ETF rule that would eliminate the lead time now necessary for new entrants into the market, a measure that would “level” the operational playing field.
Additionally, all ETFs launched to date have been required to disclose their full portfolio of holdings each day. This transparency is necessary, in the SEC’s view, to enable a properly functioning, liquid secondary market for ETF shares.
While an ETF rule would help expedite the launch of ETFs and ease entry into the marketplace, any rule adopted by the SEC is likely to continue to require full, daily transparency of the ETF’s portfolio.
However, daily transparency has served as a significant deterrent to active managers, which seek to beat the market and do not want to disclose their proprietary investment strategies, particularly if they also manage mutual funds that could be harmed by front-running or replication of their strategies.
Several firms have submitted applications to the SEC for permission to launch “non-transparent” or “opaque” actively-managed ETFs, proposing various methods to facilitate market-making while avoiding full disclosure of the ETF’s portfolio.
SEC approves exchanges' ETF rules https://t.co/dbfxNnKefO— Rival Systems (@RivalSystems) March 9, 2017
Thus far, while the SEC has provided feedback to help advance the dialogue, permission has not yet been granted to launch these novel ETFs, and some of the requests have been pending for years. So, for the time being, active strategies will, for the most part, be available only in the mutual fund structure.
With a new administration and perhaps more receptivity to innovation and capital formation, the time may be ripe for the SEC to approve a rule that will fast track “plain vanilla” ETFs and authorize by individual application non-transparent actively-managed ETFs, subject to certain conditions that support properly functioning markets.
Active managers have been losing ground to ETFs at a rapid pace, especially with the proliferation of “smart beta” ETFs, which are based on more sophisticated, multi-factor indexes and, thus, may be perceived as replacing active strategies at a lower cost. (The DOL Fiduciary Rule, although on hold for now, has accelerated this trend).
Certainly, the adoption of an ETF rule would enable other participants to join the fray at a faster pace, which would likely add new investment options to what is an already crowded ETF market. The addition of new market participants and novel strategies also could accelerate the rate at which ETF costs continue to decrease due to competition, which would benefit investors.
However, the real revolution will be felt if the SEC decides to allow active managers a seat at the table by approving non-transparent funds that can package active strategies in an ETF wrapper, which so far has been elusive.
While this development would no doubt hasten the decline of the mutual fund structure, it would also dramatically increase the strategies available through ETFs and would serve as a lifeline for faltering active managers, enabling them to compete and stay relevant despite adverse market conditions.
In short, expediting the creation of ETFs and opening the door to active managers would enhance innovation and the diversity of options in this market — a win-win for money managers and consumers.
Amy Doberman was assistant chief counsel in the SEC’s Division of Investment Management and general counsel at ProShares. She is now a partner in WilmerHale’s Investment Management Practice.
The views expressed by contributors are their own and not the views of The Hill.