Statement at Open Meeting on the Proposed Rule 6c-11 under the Investment Company Act of 1940 Governing Exchange-Traded Funds
June 28, 2018
Good morning. I would like to join the Chairman in thanking the staff in offices throughout the Commission for their hard work and collaborative effort on this proposed rule for exchange-traded funds and for answering all of my many questions. In particular, I would like to thank Zeena Abdul-Rahman, Joel Cavanaugh, Tim Dulaney, John Foley, Alexander Schiller, Sumeera Younis, Kay-Mario Vobis, Melissa Gainor, Jacob Krawitz, Tim Husson, Brian Johnson, Daniele Marchesani, Christian Sandoe and Sarah ten Siethoff.
Exchange-traded funds (or “ETFs,” as they are better known) have become increasingly popular with investors. ETFs are like mutual funds because they offer redeemable securities. And like mutual funds, each share of an ETF represents an undivided interest in the fund’s investments. However, they are different from mutual funds because an ETF’s shares trade on an exchange.
ETFs have grown from a small niche product 25 years ago to having a $3.4 trillion market presence today.[i] However, despite explosive growth in these products, our regulation has not kept up. ETFs are governed by special exemptions from rules that were originally intended for other types of funds, such as mutual funds. As a result, before an ETF’s shares can be sold, an ETF sponsor must receive relief—we call it “exemptive relief”—from several provisions of the Investment Company Act of 1940. This process can take months, if not years, and can be expensive.
The Commission has provided this exemptive relief to a variety of ETFs with different strategies, exposures, and operational nuances. This has led to a patchwork of restrictions, conditions, and representations. With over 300 exemptive orders—each of them a bit different—a very eclectic regulatory quilt has been created. Each patch on the quilt represents a personalized exemptive order, with its own details and distinctions.
Proposed rule 6c-11 would remove many of these “bespoke” patches by standardizing the conditions to which ETFs must adhere. It also would help to level the playing field by creating more regulatory consistency—for investors, for the Commission, and for fund complexes. In short, the majority of ETFs would be governed by a more uniform set of regulations.
It is worth noting, however, that the benefit of this patchwork of exemptive relief over the last 25 years is that the Commission has been able to see what works and what doesn’t. It is also now in a better position to determine which types of requests are more appropriately considered under a blanket rule, and which types of requests are more appropriate for review on an individual basis. This reminds me of an airport security checkpoint I went through recently. Luggage that the x-ray machine operator flagged was automatically sorted on the conveyor belt and sent down a different lane for closer inspection. Like the luggage, higher risk and novel ETFs will still be sent down a separate lane for a closer look.
Today’s proposed rule preserves key principles from the Commission’s past exemptive relief. For example, the rule would include many of the website disclosure requirements that are in existing orders. This includes disclosing the ETF’s current net asset value per share, market price, and premium or discount, each as of the prior business day.
Another principle that the proposal preserves is that ETF shares should generally trade at market prices that are closely aligned with the inherent value—or “net asset value”—of those shares. The Investment Company Act rules require that shares of open-end funds, like ETFs, must be redeemed at net asset value.[ii] But ETF shares trade on an exchange. This means they trade at market prices, which can be different than the net asset value of a share.[iii] Therefore, ETFs would violate the law absent an exemption from the Commission.
The Commission’s willingness to provide this exemption is grounded in an assumption. The assumption is that a process called “creation and redemption” will operate to keep market prices of ETF shares closely aligned with their net asset values.
Third parties called “authorized participants,” or “APs,” help with this alignment. In response to market demand, APs “create” shares of the ETF. They compose a basket of assets, give the basket to the ETF, and in return, the AP gets a block of the ETF’s shares.[iv] The AP turns around and sells the ETF shares on the open market, which satisfies the demand. In this way, APs are like jewelers. When jewelers see a market demand, they buy raw materials like gold and diamonds, build a ring or necklace, and sell the jewelry to consumers. On the flip side, if there is a greater demand for the precious metal or individual stones, a jeweler might buy rings and necklaces from consumers, remove the diamonds, melt the gold, and then sell the raw materials on the open market.
The creation and redemption process also gives the AP an opportunity to make money by arbitraging differences between the price of the basket’s assets and the price of the ETF’s shares. And through the forces of supply and demand, this process generally keeps the market price of an ETF’s shares closely aligned with their net asset value. As such, APs serve a critically important purpose in the creation and redemption process, which today’s proposal attempts to preserve.
The rule would also take an important leap forward by incorporating protections new to many ETFs. These protections include policies and procedures governing the construction of baskets used in the ETF’s creation and redemption process. Additionally, the proposed rule would include a requirement to disclose full portfolio holdings on a daily basis.[v] Finally, the rule would require new prospectus and website disclosures intended to help investors better understand the unique characteristics of ETFs, including their trading costs.
The proposed rule would also permit ETFs to use customized baskets for the creation and redemption process. Many ETF exemptive orders require baskets to reflect a pro rata slice of the ETF’s portfolio holdings. Custom baskets, on the other hand, do not represent a pro rata slice of the ETF’s portfolio holdings. Pro rata baskets are like slices of cake—you generally get representation of all the cake’s ingredients in each slice. Custom baskets are like scooping out only certain pieces of fruit from a fruit salad but not others—your serving may not reflect the overall composition of the fruit salad.
Custom baskets can have benefits. For example, by using a custom basket, a portfolio manager can add securities to the ETF’s portfolio through the creation process, or remove securities through the redemption process. The portfolio manager adds a security, for example, by including in the creation basket a security not otherwise in the ETF’s portfolio. When the AP gives the ETF the basket of securities, that security will be added to the ETF. This can be beneficial to the ETF because it shifts the cost of making portfolio changes from the ETF to the AP who is effecting the creation transaction.
Several older ETF orders allow for basket flexibility. ETFs that rely on those older orders may experience fewer costs and greater efficiency in the creation and redemption process. As a result, ETFs governed by those older orders could have an advantage.
The Commission’s current exemptive orders generally require baskets to reflect a pro rata slice of the portfolio. This requirement is due to a fear that an AP will be in a position to take advantage of an ETF because of its special relationship with the ETF. For example, an AP could get rid of a less-desirable security by giving it to the ETF through a customized creation basket. This is called “dumping,” and it’s like in a card game when you discard into the central pile the cards that you would prefer not to hold on to. Alternatively, an AP could ask to receive highly desirable securities in a customized redemption basket, leaving the less desirable ones in the ETF. This “cherry picking,” as it’s called, is like selecting the best looking food items out of a buffet and leaving the rest for everyone else.
To prevent “dumping” and “cherry picking” the proposed rule would permit custom baskets only where the ETF adopts written policies and procedures governing custom baskets. Specifically, the policies and procedures would include parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders. The policies and procedures would also include a list of employees at the ETF’s adviser who will review each custom basket for compliance.
Permitting custom baskets may level the playing field—a stated goal of this proposed rule. But I wonder whether it does so by lowering the bar instead of raising it. I would encourage commenters to weigh in on the proposed custom baskets paradigm. Will the use of custom baskets promote a more efficient creation and redemption process? Is the policies and procedures requirement specific enough to prevent wrongdoing, like “cherry-picking” or “dumping”? Should we instead only allow custom baskets in certain defined scenarios, and only under specified conditions?
Importantly, the proposed rule would also require ETFs to maintain records of each custom basket used throughout the day. This is done, in part, so that our exam staff would be able to ensure ETFs are not taking advantage of the flexibility that custom baskets provide. But should we also require ETFs to disclose at the end of the day each custom basket used? Such transparency could promote trust between an ETF issuer and its APs, which might stimulate arbitrage activity at times when it is needed the most. It would also be a way for the market to self-police, reducing the Commission’s regulatory costs and making the market more efficient.
More broadly, while the proposed rule addresses the patchwork of regulatory exemptions that cover the majority of ETF assets, it doesn’t answer several questions about exchange-traded products generally.[vi] For instance, it does not broadly address the use of leveraged and inverse ETFs, which are essentially ETFs on steroids. Leveraged or inverse ETFs are, for example, ETFs that seek daily investment results that correspond to three times the daily performance of an index or the inverse of the daily performance of the index, respectively. These ETFs are generally intended to be trading products. They may not be suitable for many buy-and-hold investors. Are leveraged and inverse ETFs appropriate for all investors? If not, for whom are they appropriate and under what circumstances? What is the impact of these ETFs on the underlying markets, particularly during periods of stress? Ultimately, I agree with the outcome that leveraged and inverse ETFs should not be permitted to rely on this proposed “plain vanilla” ETF rule, but we still need to address these questions.
Furthermore, the rule also does not address exchange-traded products that are not governed by the Investment Company Act, such as exchange-traded notes. Again, this may be the right outcome for the rule in front of us today, but I think we need to avoid thinking about exchange-traded products as a monolith. Are investors confused about the different types of exchange-traded products available and are they confused about the specific risks of each? Is there a better approach to naming these products to reduce investor confusion? Exchange-traded notes, for example, operate very differently, and have different risks, than Investment Company Act ETFs.
Although the rule before us today does not cover all of these issues, I am encouraged to see that the Chairman and staff have submitted this proposal for the Commission’s consideration. As I have said before, we need overarching and consistent ETF regulation and this is an important step in the right direction. I am pleased to support putting this proposal out for public comment.
[i] Based on Bloomberg data.
[ii] Rule 22c-1 of the Investment Company Act of 1940 states that “[n]o registered investment company issuing any redeemable security . . . shall sell, redeem, or repurchase any such security except at a price based on the current net asset value of such security . . . .”
[iii] When the market price is higher than the net asset value per share, it is called a “premium”; when the market price is lower than the net asset value per share, it is called a “discount.”
[iv] The opposite of this process is called redemption.
[v] While many ETFs voluntarily disclose full portfolio holdings on a daily basis, some are not currently required to do so pursuant to their exemptive orders.
[vi] The proposed rule also would stop short of completely leveling the playing field for all “plain vanilla” ETFs governed by the Investment Company Act. The rule would leave out ETFs that are structured as a share class of an open end investment company series, alongside mutual funds structured as different share classes of the same series. How important is it to regulatory certainty and an efficient arbitrage environment to create consistency across all types of plain vanilla ETFs? I would encourage commenters to weigh in on this point.