A Quarter Century of Exchange-Traded Fun!

Remarks at the ETFs Global Markets Roundtable

Since the first exchange-traded fund (“ETF”) launched in 1993, ETFs have proven to be one of the most useful and successful innovations in the registered fund space under the Investment Company Act (“Act”) of 1940. The innovation did not stop with that first ETF. Besides being one of the fund industry’s most successful financial innovations, ETFs have been, and have the potential to continue being, the wrapper within which future financial innovations occur. Today, I want to share my thoughts on how ETFs can be used to facilitate further financial experimentation and innovations and how the SEC can fulfill its role of protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets without unnecessarily slowing this innovation. Before I begin, I must give the standard disclaimer: The views I represent are my own and do not necessarily represent those of the Commission or my fellow Commissioners.

People who call me “CryptoMom” often ask me how long it will be before a bitcoin-based exchange-traded product (“ETP”) is approved by the SEC. My typical answer is: I do not know, particularly because the initial decisions are made at the staff level, but it may be a long time. To provide some context, it is helpful to think about how the SEC has dealt with ETFs—one category of ETP—in their twenty-five year history. As I mentioned, ETFs have been around since 1993 after getting the green light from the Commission in 1992.[1] 1993 was a momentous one for me because it was in that year that my oldest niece was born. Just the other day, I found a picture of her at less than one year old sitting on the living room floor with a happy, toothless smile. She now has teeth, her master’s degree, and a successful career. In short, regardless of her aunt’s nostalgia for that pudgy, smiley baby, she is all grown up.

ETFs as an asset class also have grown up since the first one was launched in 1993, but the SEC is still smothering them with personalized attention as if they were infants. ETFs registered with the Commission now have approximately $3.8 trillion in total net assets.[2] All of this stunning growth has occurred through our exemptive application process. Would-be ETF sponsors have applied for exemptive orders, which have afforded them the necessary flexibility under our securities laws. The Commission has granted more than 300 such orders, each a separately negotiated permission slip for operation.

Last year, we proposed a rule to codify the exemptive relief we had been doling out for the past quarter century.[3] A rule would not only standardize the conditions on the relief, but would make it easier for fund sponsors to get their ETFs to market. A level playing field without long approval queues makes for better competition, which is good for investors, capital formation, and the health of our markets. We are grateful for the helpful comments, and I hope that we will be able to finalize a rule this year. It is remarkable to think an innovation that was launched in 1993 is just now getting its own rule. To be fair, we did propose a rule ten years ago, but it was one of the casualties of the financial crisis.[4] Since the 2008 proposal, ETF assets have continued to grow and have done so at a rate that outpaced the total growth in mutual fund assets. From 2008 through 2017, ETF assets grew from approximately $530 billion to $3.4 trillion.[5] Over the same period of time, mutual fund assets increased from approximately $9.6 trillion to $18.7 trillion.[6]

Perhaps the length of time it has taken to wend our way toward an ETF rule is not particularly noteworthy, but it is cautionary. We like to see a little grey around the product’s temples before we grant it formal recognition. When we are confronted with a new product, it takes us some time to get comfortable with it. We explore its many aspects, worry about its potential to harm investors and the markets, and analyze how best to condition the relief. Twenty-five years to work through our issues with plain vanilla ETFs does not bode well for ETFs and other ETPs that we believe to be something other than plain vanilla, including those with a cryptocurrency angle.

The popularity of ETFs is not hard to understand. ETFs provide investors with a vast and diverse range of investment options, which are easy to enter and exit with low transaction costs. Among the benefits that ETFs offer are operating expenses that are lower than comparable mutual funds’ expenses, tax efficiencies, and intra-day trading on the secondary market. It is not surprising then that many investors view ETFs as an expedient and cost effective option for their portfolios.

ETF assets are concentrated in index-based funds.[7] Part of the reason for the concentration in index-based funds is that the Commission has been slow in providing the relief necessary for non-indexed based ETFs to operate. Despite the Commission’s lack of speed in issuing actively managed ETF exemptive orders, it is interesting to contrast the outflows that actively managed mutual funds have experienced in recent years with the inflows that actively managed ETFs have enjoyed since 2008.[8] From January 2008 through March 2019, actively managed ETFs registered with the Commission had inflows of approximately $79 billion.[9]

The Commission has proceeded cautiously with approving new types of ETFs. For example, the Commission only just yesterday authorized its first non-fully transparent actively managed ETF.[10] In addition, while the Commission years ago issued a few orders allowing leveraged and inverse ETFs to operate, it has not issued any additional orders since then.[11] Our failure or prolonged delay in approving orders sometimes carries with it a tinge of merit regulation. Are we substituting our own judgment for that of the market? It seems that in at least some cases the Commission is overly concerned about the potential worthiness of the investment, which contributes, at the very least, to significant delays in the issuance of exemptive orders. It is extremely difficult for a fund sponsor to plan the launch of a new product with the great unknown of Commission timing lurking in the background. What investors want today might not be what investors want ten years from now.

The SEC granted the first actively managed ETF orders in 2008—fifteen years after the introduction of index-based ETFs.[12] Since then, we have issued approximately 100 exemptive orders for fully transparent actively managed ETFs.[13] Until yesterday, non-fully transparent ETFs remained nothing more than a glimmer of hope in several sponsors’ eyes.[14] Fully transparent, actively managed ETFs obviously reveal what they invest in and to what degree. Despite having to give away their secret sauce, these funds have flourished. As I mentioned, the outflows that have characterized actively managed mutual funds since 2008 have not manifested themselves for fully transparent actively managed ETFs, which have grown to, by one measure, approximately $85 billion in assets.[15] Especially now that the Commission has given the green light to the first non-fully transparent actively managed ETF, actively managed ETFs likely will continue to grow, perhaps even at a faster pace. I am, of course, not weighing in on the merits of these ETFs, but the potential to guard the recipe for the secret sauce a bit more closely may be attractive to ETF sponsors, who may in turn create products that investors want.

It has taken us a while to get to this point. The first applicant for exemptive relief to allow anon-fully transparent actively managed ETF publicly filed its application in September 2011.[16] Eight years sounds like a long time, but it is deceptively short when you consider that discussions regarding an exemptive application can begin years before the filing of the initial public notice of the application. Admittedly, the issues presented by a non-fully transparent ETF are more difficult than those in previous ETF applications, but the delay nevertheless seems unreasonable.

I understand the concerns about ensuring that the arbitrage mechanism would work to keep the NAV and market price of these ETFs close. An effective arbitrage mechanism has been a key consideration in the Commission’s exemptive orders for ETFs. As Henry Hu and John Morley argue in their thoughtful article on ETFs, “[t]he most distinctive feature of the ETF is its arbitrage mechanism.”[17] If the arbitrage mechanism works properly, the creation and redemption process, along with secondary market trading in ETF shares, keeps the market price of ETF shares at or close to the net asset value per share of the ETF.[18]

In the case of the recently issued non-fully transparent actively managed ETF order, the ETF sponsor, market makers, authorized participants, and several economists thought that the arbitrage mechanism would work and were willing to offer and make markets in these ETFs.[19] Yet it still took a considerable amount of time for the Commission to get comfortable. Ironically, at one point late in the process, questions even were raised within the Commission as to whether these ETFs would be too transparent under the conditions then being considered for relief, thus allowing others not invested in these ETFs to reverse engineer their secret sauce.

I hope that the Commission moves expeditiously on the remaining outstanding requests for exemptive relief for non-fully transparent actively managed ETFs. It might be considered odd coming from a government regulator, but I believe in the premise that markets are good at merit regulation. Investors deciding where to invest their hard-earned money can be tough critics and can kill a product that took regulators years to approve in a matter of months or even less.

Another example of Commission indecision in the ETF space is the Commission’s treatment of leveraged and inverse ETFs, which are also called geared ETFs. Leveraged ETFs seek to provide returns that exceed the performance of a market index by a specified multiple over a period of time. Inverse ETFs seek to provide returns that have an inverse relationship to, or provide returns that are an inverse multiple of, the performance of a market index over a fixed period of time. The Commission issued an order to ProShares in 2006 allowing it to operate the first leveraged and inverse ETFs.[20] After the ProShares order, the Commission issued similar orders to Rydex in 2007 and Rafferty Asset Management in 2008 (the funds offered pursuant to this order are known as the Direxion ETFs).[21] After that bold set of moves, the Commission got cold feet; since then, it has not issued orders to any other sponsors allowing for the operation of leveraged and inverse ETFs.[22]

The Commission staff offered a reason for timidity in 2010, when it announced a review to evaluate the use of derivatives by registered investment companies, including ETFs.[23] Pending completion of this review, the staff would defer consideration of exemptive requests under the Investment Company Act relating to ETFs that would make significant investments in derivatives, including certain actively-managed and leveraged ETFs.[24] The moratorium still continues for new exemptive relief for leveraged and inverse ETFs.[25]

The fact that the moratorium is not dead likely reflects deeper concerns about these products. There are reasonable ways to address these concerns, but refusing to allow new geared ETFs to come to market is not one of them. One concern relates to the use of derivatives. Leveraged and inverse ETFs that operate under exemptive orders from the Commission did not seek or receive relief from the Investment Company Act’s limits on borrowing (use of derivatives).[26] The relief was simply the same relief all other ETFs have obtained. This standard relief allows an ETF to operate even though only authorized participants may purchase and redeem shares from the fund and all other investors must purchase and redeem their shares either through the authorized participant or, as is the case for retail investors, purchase and sell their shares on the secondary market.

These funds did not require an exemption in relation to the amount of leverage they sought to use, which is not surprising given the reality that there were and still are mutual funds that pursue similar leverage strategies.[27] These mutual funds did not seek an exemptive order from the Commission to pursue their leverage strategies because such use does not contravene the borrowing limits set forth in section 18 of the Act, at least as understood by the fund industry (and the Commission and Commission staff) prior to the Commission’s 2015 proposal of rule 18f-4 under the Act.[28] Therefore, the use of derivatives by leveraged ETFs within the limits of section 18 of the Act does not warrant a moratorium. As we consider whether to take action with respect more generally to funds’ use of derivatives, we can address any concerns about geared ETFs’ use of derivatives.

The moratorium seems also to reflect the Commission staff’s understandable concerns, particularly following the 2007-2009 financial crisis, about retail investors investing in leveraged and inverse ETFs. Prior to the 2010 moratorium, Commission staff, in conjunction with FINRA, issued an investor alert regarding leveraged and inverse ETFs because they believed “individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds (ETFs).”[29] Commission staff’s main concern was that retail investors did not understand that most of these products “reset” daily and are designed to achieve their stated objectives on a daily basis. “Their performance over longer periods of time . . . can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.”[30]

While I appreciate the concern for retail investors, our fund regulatory regime is based on disclosure of material information so that investors can make an informed decision. The disclosures being made by leveraged or inverse funds to inform investors about the issue have been pretty unvarnished. In fact, as noted in the release for proposed rule 18f-4, following the financial crisis one lawsuit was brought against one of the sponsors of leveraged ETFs, alleging that the funds’ registration statements contained material misstatements or omissions.[31] The Court of Appeals for the Second Circuit, in affirming the district court’s dismissal of the plaintiffs’ claims, explained that:

The earliest relevant prospectuses make absolutely clear that the ETFs operated pursuant to daily investment objectives, that they utilized leveraged investment techniques to achieve those objectives, and that mathematical compounding combined with leveraging prevented the ETFs from achieving their stated objectives over a period of time greater than one day. [The] prospectuses make clear that ETFs used aggressive financial instruments and investment techniques that exposed the ETFs to potentially “dramatic” losses “in the value of its portfolio holdings and imperfect correlation to the index underlying.”[32]

As I read them, leveraged and inverse ETF prospectus disclosures clearly lay out their investment objective, strategy, risks, and target audience—which they underscore is not your typical buy and hold retail investor.[33]

Denying new fund sponsors the ability to offer leveraged and inverse ETFs has created an oligopoly for the ETF sponsors that obtained a leveraged or inverse ETF order before the moratorium took effect. New sponsors cannot enter the market and thus investors seeking to invest in leveraged and inverse fund products must choose among the suite offered by the two remaining ETF sponsors[34] or from among the mutual funds that offer similar investment strategies. Given the advantages of easy entry and exit that the ETF structure offers, the leveraged and inverse space is one in which investors might particularly welcome additional ETF options.

Our unwillingness to allow more competitors to offer geared ETFs seems to be another example of our denying or curtailing access to an investment product that would be useful to some investors. The combined effect of the investor alert and moratorium has caused many investment professionals to refuse to offer leveraged and inverse ETF investments to retail investors. The same “protect them from their wild selves” logic courses through our accredited investor definition,[35] which keeps most investors out of the private markets through which they could diversify their portfolios and gain exposure to companies during their early growth phases. Our urge to protect investors is laudable, but protecting them by limiting their options for portfolio diversification and risk mitigation is not the approach Congress directed us to take.

Last year’s ETF proposal omitted geared funds, although it did ask questions about whether they should be included in the final rule.[36] The proposal also failed to address an important aspect of the ETF approval process. After going through the Division of Investment Management, a sponsor, working with the listing exchange, has to get the product listed. Because ETFs trade on exchanges, part of the ETF process involves the relevant exchange getting its listing standards approved by the Commission under Exchange Act Rule 19b-4. The exchange works with the Division of Trading and Markets during this process, and the fund sponsor is one step removed, which can be frustrating; sponsors have to work through the listing exchange, rather than directly with our Trading and Markets staff. The proposal would have been more meaningful if it had taken a cross-divisional approach. Even with these limitations, I commend Dalia Blass for her hard work on the ETF proposal and other projects. With unflagging energy and great care, she has tackled issues that have long needed attention.

One issue that I would like to see the Division of Investment Management add to its agenda is the marketplace’s interest in gaining exposure to bitcoin and other cryptocurrencies through a registered investment company. Despite interest from sponsors and investors, the Commission has yet to entertain an exemptive application for an ETF or approve an exchange rule allowing for the operation of crypto ETFs or other ETPs. The Commission has expressed a number of concerns from market manipulation to custody to retail investor protection. We need to do a better job of fostering open dialogue about the first two topics.[37] On the third issue—retail investor protection—the reality is that retail investors will get access to these products, even if we do not allow them to do so through SEC regulated products and venues. Again, it is not the Commission’s role to be the arbiter of what constitutes an appropriate investment or to act as an investment adviser.

In disapproving a proposed rule change to list and trade shares of the Winklevoss Bitcoin Trust, the Commission focused on the underlying characteristics of bitcoin and the spot markets in which it trades.[38] Instead of focusing on the merits of bitcoin as an investment, the Commission should have considered how the exchange-traded wrapper would work and how increased participation by institutional investors in the bitcoin market could have led to bolstered defenses against theft, greater investment in custody solutions, and lower likelihood of market manipulation.[39]

While the Winklevoss Bitcoin Trust would have been an ETP and not an ETF, in reviewing possible applications for an ETF that invests in crypto assets, I would focus on the same factors that I discussed in my dissent to the Commission’s rejection of the proposed listing of the Winklevoss Bitcoin Trust. The ETF wrapper provides ease of investor movement into and out of the investment throughout each trading day, improved price arbitrage, and the possibility of increased participation by institutional investors with the attendant benefits their participation would provide. In addition, an ETF wrapper ensures that the Commission and its staff would directly regulate the entity, as it would be registered as an investment company with the Commission. This would provide Commission staff with the ability to examine the entity and keep abreast of any issues that might arise in the operation of the fund.

All that said, it is important to remember that, if the SEC were to permit a cryptocurrency ETP to trade in our markets, it would not be a seal of approval. In other words, investors would still have to do their own homework, study the product disclosures, assess their own appetites for risk, determine how much of a loss they could stomach, and—if those losses materialize—learn from them and refrain from coming to the SEC asking to be made whole.

Thank you for the chance to talk with you today. Since their introduction twenty-five years ago, ETFs have developed into an interesting and important market phenomenon. Investors have found that the ETF wrapper minimizes the costs they pay and hassles they incur in connection with their investments. I know we are all looking forward to the next quarter century of exchange-traded fun! I hope that the next twenty-five years will be characterized by well-calibrated rules, lots of innovation, and many investors whose portfolios have benefited from that innovation.