The key distinguishing innovation characteristic of all ETFs and critical for their successful operation is the existence of a secondary market for their shares on a securities exchange, where the shares trade throughout the trading day like any other equity security at prices determined by supply and demand, coupled with daily creation and redemption of shares at net asset value (NAV) per share in large aggregations (called baskets) by certain eligible financial institutions. This innovation tends to cause the market price per share to track the NAV per share over time, because differences between market price and NAV create arbitrage opportunities for investors who can exploit them by increasing or decreasing the supply of ETF shares through creations or redemptions of ETF shares at NAV in baskets until the market price and the NAV per share come back into equilibrium. This affords retail investors, who obtain their exposure to ETFs in the secondary market on a securities exchange and depend for liquidity in their ETF holdings on the existence of such a secondary market, a high degree of assurance that they will be able to enter and exit an investment in an ETF at a price that is a close approximation of NAV.
- To date, all ETFs have been required to obtain an SEC order exempting the ETF from certain provisions of the 1940 Act, in order to offer and redeem baskets and to list their shares on a securities exchange. Without this relief, ETFs could not exist. The first exemptive orders took several years to obtain. Since then, the time required to obtain an order has decreased, although it is still substantial. More than 300 exemptive orders have been issued since 1992. The exemptive orders that have been obtained have not been identical, and inconsistencies among orders have afforded certain ETFs and their sponsors competitive advantages. One purpose of the ETF Rule is to create a “consistent, transparent, and efficient regulatory framework for the regulation of most ETFs and help level the playing field for these market participants.” To this end, the aspects of existing exemptive orders relating to the formation and operation of ETFs, as well as certain relief specific to master-feeder ETFs, will be rescinded within one year of the effective date of the ETF Rule.2,3
- In particular, to be able to operate as an ETF, an open-end management investment company requires relief from Sections 2(a)(32) and 5(a)(1) (requirement that shares be individually redeemable),4 Section 17(a) (affiliated transaction restrictions), Section 22(d) (requirement that shares be sold at a current public offering price disclosed in the prospectus) and Rule 22c-1 (requiring sales only at a price based on NAV) and Section 22(e) (prohibition on delay of redemptions).
The relief will be available only to an issuer that satisfies certain conditions.
Website Disclosure Requirements. The SEC believes that full transparency to the portfolio holdings, and proposed portfolio holdings, of an ETF is essential to the proper functioning of the arbitrage mechanism that causes the market price per share of an ETF’s shares to tend to track its NAV per share closely and that close tracking is important for the protection of retail investors who must transact on the market at the market price (not NAV). Therefore, the ETF must disclose prominently on its website each business day
- its current NAV per share, market price per share and the premium/discount between them as of the end of the preceding business day
- before the opening of trading on its primary listing exchange, its portfolio holdings that will form the basis of the next calculation of NAV per share
- the following information for each portfolio holding: (1) ticker symbol, (2) CUSIP or other identifier, (3) description of holding, (4) quantity of each security or other asset held and (5) percentage weight of the holding in the portfolio
- the median bid-ask spread over the most recent 30 calendar days
- a table and chart showing the number of days the ETF’s shares traded at a premium or discount to NAV during the most recently completed calendar year and the calendar quarters of the current year
- a line graph showing the ETF’s shares’ premiums and discounts for the most recently completed calendar year and the completed calendar quarters of the current year
- if the ETF’s shares traded at premiums or discounts greater than 2 percent for more than seven consecutive trading days, for at least one year thereafter, an acknowledgement of that fact and a discussion of the factors the ETF believes contributed materially to that phenomenon.
Basket Procedures. The ETF must adopt and implement written policies and procedures that govern the construction of baskets and the process for the submission and acceptance of creation and redemption baskets. If the ETF uses a “custom basket” (i.e., baskets that do not reflect a pro rata representation of the ETF’s portfolio holdings or that differ from other baskets used in transactions on the same business day), it must adopt enhanced procedures that set out detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, and the process for revising or deviating from those parameters, and must specify the titles or roles of the employees of the ETF’s investment adviser that are required to review each custom basket for compliance.
Additional Condition. Additionally, the ETF must use its portfolio holdings as of the close of business on the prior business day to calculate the next NAV.
The ETF Rule does not rescind the Section 12(d)(1) exemptive relief previously obtained, and extends existing relief from the antipyramiding rules in Section 12(d)(1) that has been granted in some exemptive orders permitting “fund of funds” arrangements.
The ETF Rule is available to index-tracking funds and actively managed funds so long as they can satisfy its conditions. The requirement of full transparency has discouraged some sponsors from bringing actively managed ETFs to market.
The ETF Rule does not distinguish between index-based ETFs that use affiliated index providers as opposed to third-party index providers.
The ETF Rule does not include a requirement that the ETF publish an indicative intraday NAV every 15 seconds during the trading day, which is a feature of all orders granted previously.
In adopting the ETF Rule, the SEC compromised on a proposed requirement for ETFs to disclose how bid-ask spreads affect the return on a hypothetical investment. Under the final rule, ETFs must disclose only the median bid-ask spread over the most recent 30 calendar days.
The SEC declined to take additional action to exempt ETF insiders and large shareholders from certain Exchange Act Section 13(d) and Section 16 reporting requirements beyond the relief previously provided in several staff no-action letters, which was conditioned, among other things, upon there being no material deviation between the ETF’s market price and NAV per share. See PDR Services Corporation, SEC Staff No-Action Letter (pub. avail. December 14, 1998); Select Sector SPDR Trust, SEC Staff No-Action Letter (pub. avail. May 6, 1999).
Comments and Criticisms
Clause (b)(3) of the rule, which provides relief from the prohibited transaction rules in Sections 17(a)(1) and 17(a)(2), is available to a first-tier affiliated person or a second-tier affiliated person of the ETF only if such person is classified as such by reason of holding with power to vote 5 percent or more of the ETF’s shares or holding with the power to vote 5 percent or more of the shares of any investment company that is a first-tier affiliated person of the ETF. The relief would not reach those who are first-tier affiliated persons or second-tier affiliated persons due to other relationships, such as being an affiliated person of the ETF’s investment adviser, and only provides relief with regard to the creation and redemption of baskets. Commenters arguing for an expansion of the pool of affiliates covered by the proposed relief have pointed out that (1) affiliates of an ETF’s investment adviser represent an untapped pool of institutional investors (or authorized participants) who could play an important role in ensuring that the arbitrage mechanism works and in seeding an ETF with in-kind investments (potentially reducing transaction costs for investors), and (2) prior exemptive relief and the formulation of Rule 6c-11 as proposed by the SEC in 2008 would have included additional affiliates. The SEC declined to expand the scope of affiliated persons covered by the exemption.
Some commenters have objected to certain of the required website disclosures concerning trading information and costs, particularly bid/ask spreads and market price premiums/discounts to NAV. These matters are outside the control of the ETF and its sponsor/investment adviser, and the information must be acquired from third parties. Concerns have also been raised about inconsistency of presentation methodologies from sponsor to sponsor and the potential for investor confusion.
1 This discussion is limited to ETFs that are required to be registered as investment companies under the Investment Company Act of 1940, as amended (the 1940 Act), which includes the vast majority of all ETFs listed on securities exchanges in the United States today.
2 In conjunction with the adoption of the ETF Rule, the SEC is also amending certain exemptive orders that automatically expire on the effective date of a rule permitting the operation of ETFs to give them time to make any adjustments necessary to rely on the ETF Rule. The ETF Rule is effective 60 days after publication in the Federal Register.
3 The ETF Rule will not be available to nontransparent ETFs, ETFs organized as unit investment trusts, leveraged or inverse ETFs, or ETFs structured as a share class of a multiclass fund, all of which will continue to rely on their prior exemptive relief.
4 Under the ETF Rule, ETFs relying on the rule will be eligible for the “redeemable securities” exceptions in Rule 101(c)(4) and Rule 102(d)(4) of Regulation M and Rule 10b-17(c) under the Securities Exchange Act of 1934, as amended (the Exchange Act), in connection with secondary market transactions in ETF shares and the creation or redemption of baskets. Similarly, ETFs relying on the rule would be within the “registered open-end investment company” exemption in Rule 11d1-2 under the Exchange Act. To further reduce regulatory complexity, administrative delay and eliminate potential inconsistencies between the ETF Rule and related Exchange Act relief that ETFs must obtain to operate, the SEC is issuing an order granting exemptive relief to ETFs that rely on the ETF Rule from the requirements of Section 11(d)(1) of the Exchange Act and Rules 10b-10, 15c1-5, 15c1-6 and 14e-5 under the Exchange Act, subject to certain conditions. See Order Granting a Conditional Exemption from Exchange Act Section 11(d)(1) and Exchange Act Rules 10b-10; 15c1-5; 15c1-6; and 14e-5 for certain Exchange Traded Funds, Release No. 34-87110 (September 25, 2019).
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