Statement at Open Meeting on Exchange-Traded Funds

Thank you, Chairman Clayton.

I want to thank all of the staff that worked on this recommendation.  Your efforts and patience are noticed and much appreciated by the Commission.

Today, we are considering a recommendation to propose a new rule to permit exchange-traded funds ("ETFs"), subject to certain conditions, to operate without the expense and delay of obtaining an exemptive order.  This rule is long overdue.  The delay is symptomatic of a larger institutional problem at the Commission.  We are reluctant to embrace or even acknowledge innovation, which means that twenty-five years can go by before we allow our rulebooks to incorporate a product that has a central place in investor portfolios.

One downside of our having waited so long to promulgate a rule is that differences across exemptive orders over time have created an uneven playing field.  Today's proposal would address that problem by replacing existing orders with a uniform regulatory framework.  

Currently, for example, as we have heard, ETFs are subject to different restrictions on the composition of the baskets for which they issue or redeem creation units.  Our earlier orders have few restrictions on basket composition and do not limit baskets to a pro rata representation of the ETF's portfolio holdings.  Over time, our ETF exemptive orders placed tighter restrictions on the composition of the baskets and began to require that baskets generally correspond pro rata to portfolio holdings with only limited exceptions.  The additional flexibility as to the composition of baskets in our earlier exemptive orders provides early applicants an advantage over funds that received later orders.  Today's rule proposal would allow all ETFs to use baskets that do not correspond pro rata to portfolio holdings.  Funds that use such baskets or that use different baskets on the same day ("custom baskets"), however, would be subject to additional requirements. 

I am looking forward to the input of investors, market participants, academics, and others. I am particularly interested in comment on a couple of issues.  First, the proposed rule explicitly excludes leveraged and inverse ETFs.  I would have preferred to write a more comprehensive rule, but the release does a nice job asking questions about the potential for including such funds, and I hope that commenters will weigh in on whether and how the rule could accommodate such funds.  These funds are here to stay, and a rule that accommodated them would benefit investors, fund sponsors, and the Commission.

A second issue of concern is that the rule addresses only one element of the frustratingly long and multi-faceted ETF approval process.  Another difficult aspect of the process is getting the products listed.  Because ETFs trade on exchanges, part of the ETF process entails the relevant exchange getting its listing standards approved by the Commission under Exchange Act Rule 19b-4.  The fund sponsor is one step removed from the process, but has an obvious interest in how and in what timeframe it plays out.  I welcome comment on how we can make this process work more smoothly.

Before I close, I will take a moment to quibble with the rule text, which requires advisers to adopt and implement policies and procedures concerning custom basket construction "that are in the best interests of the exchange-traded fund and its shareholders."[1]  The proposing release in discussing this requirement notes that the investment adviser to the ETF "is in the best position to design and administer the custom basket policies and procedures and to establish parameters that are in the best interests of the fund and its shareholders."[2]  However, this requirement is contrary to the adviser's fiduciary duty to its client: the fund.  As we are all aware an investment adviser's client is the fund and not the fund shareholders.  The investment adviser owes a fiduciary duty to the fund, not to the fund shareholders.  After all, shareholders are not uniform—each fund shareholder has her own tax considerations, mix of investments, investing timeline, and risk tolerance.  Asking a fund adviser to manage custom baskets in the best interest of shareholders, whose best interests are varied and unknown by the adviser, is asking the impossible.  I hope that if and when the Commission considers the adoption of this rule, we modify this requirement so that it allows the adviser to focus on the best interests of the fund.  More generally, I hope that this language does not creep into other rules.

Thank you again to the staff for the recommendation, which I am happy to support. I have no questions.