Exchange-traded funds have been one of the most popular segments of Wall Street for years, with assets seeming to hit records on a monthly basis, but a potential upcoming regulatory change could accelerate the already-blistering levels growth in the industry.
The Securities and Exchange Commission will next week hold a meeting that could result in the adoption of a new rule that could ease the regulatory burden of launching a new ETF.
Currently, ETFs are covered by the Investment Company Act of 1940, a rule that was primarily designed for mutual funds. While ETFs have some elements in common with mutual funds, in that they hold baskets of securities like stocks or bonds, they differ in that they are traded intraday on exchanges, like stocks.
Because of this, whenever an ETF sponsor wants to launch a new fund, the sponsor has to get “exemptive relief” from the SEC. This frees ETFs from some of the regulatory framework that covers mutual funds, such as their single-day pricing. Whereas mutual funds only trade and price at the end of the trading day, ETFs trade throughout the session.
At the June 28 meeting, the SEC will consider adopting an ETF-specific rule that is expected to allow sponsors to bypass this step, and instead, simply hold them to generic-release standards, which have more basic requirements for listing, such as minimum liquidity levels.
“This would be a change that is long overdue. It reflects that ETFs are no longer the exception, but the rule for how investors want to access markets. It’s about time that they had a rule for themselves, and not one that held them to the standards of mutual funds,” said Phil Bak, the former head of ETF listings at the New York Stock Exchange who is currently the chief executive officer of Exponential ETFs. “This rule has been suggested for years; that it is finally starting to get traction shows you how far the industry has come.”
Removing this step would lower the cost of launching a new fund, as the cost of preparing and filing for the exemption can cost between $50,000 and $75,000, according to Mike Venuto, chief investment officer of Toroso Investments (Bak put the cost at closer to $20,000). It would also shorten the amount of time needed to launch a new fund, although sponsors would still need to have their prospective products reviewed, a process that Venuto said typically takes about 75 days.
Lowering the expense of launching a fund could mean ETF sponsors are able to lower fees, exacerbating a trend that has already seen costs drop precipitously.
Currently, there are nearly 1,900 U.S.-listed ETFs, according to research-firm ETFGI, with 55 debuting thus far in 2018. There are nearly $3.5 trillion in U.S. ETFs assets, up from $3.3 trillion at the end of 2017. (ETFGI’s data is through May.)
Despite the strong growth that the category has seen, ETFs are dwarfed in size by mutual funds, an investment vehicle that admittedly had a head start of several decades (the first ETF debuted in 1993). According to 2017 data from Goldman Sachs, ETFs own about 6% of the U.S. equity market, compared with the 24% held by mutual funds.
“Passing the rule would level the playing with mutual funds,” Venuto said. “It would be awesome for the industry, and a bold statement from the SEC that this is a structure that’s now accepted. The benefit of that is really intangible.”
The rule would come at a time when pretty much every asset class, region, strategy, and sector of the global economy has a dedicated ETF. In a sign of how much of the ground has been covered, there have been no fewer than seven ETFs launched in 2018 dedicated to the theme of blockchain, the ledger technology best known as the underpinning to bitcoin and other cryptocurrencies.
Venuto speculated that the biggest impact of the rule would involve actively managed ETFs, an investment strategy where the holdings of a fund are selected at the discretion of a manager. While there are a few actively managed ETFs on the market currently, the industry is dominated by passive products, which mimic the performance of an index like the S&P 500
Investors have shown limited interest in actively managed ETFs — roughly 1% of ETF assets are held in them — and active management has in general fallen out of favor as investors move to passive products. However, the rule change could enable active managers to cheaply offer an ETF share class of their existing funds. As ETFs are seen as offering greater tax efficiency than mutual funds, this could increase the popularity of the format.