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The US ETF market, time for some rules

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By Sean M Tuffy, Brown Brothers Harriman – A milestone in the Exchange Traded Fund (ETF) industry was reached in November when the SEC approved an application for a new fund structure, the Exchange Traded Managed Fund (ETMF), to trade on the NASDAQ Stock Market. 

It is the first non-transparent, actively managed ETF approved by the SEC that does not require daily disclosure of holdings. Many industry observers believe that the non-transparent ETF will be the next big thing in the industry. Regardless of the ultimate success of the ETMF, its approval highlights a critical flaw in US regulatory rules that govern ETFs – specifically, that there aren’t any. In other words, instead of a formal ETF rule set there is a collection of SEC rulings on specific ETF products.

Investment characteristics of ETFs differ from mutual funds. One of the biggest differences is that ETFs are traded on exchanges throughout the day while shares of mutual funds trade directly with the fund company and they are priced at the end of day. As a result, ETFs do not meet all of the requirements of the Investment Company Act of 1940 (popularly known as the ’40 Act). The ’40 Act, which is monitored by the SEC, established the rule set for ETFs in the US. In order to launch an ETF, an asset manager must apply to the SEC for an exemption from certain provisions of the ’40 Act. So, technically, the SEC did not actually approve the ETMF application. Rather, the SEC approved the application’s exemption from parts of the ’40 Act.

This tactical approach of regulating ETFs by exception creates three key problems. First, requiring every ETF to apply for an exemption from the ’40 Act creates an administrative burden for the SEC and the ETF provider. It has been reported that it can take up to 12 months, if not longer, for an exemption to be granted. The lengthy process slows the launch of new funds, deprives investors of new opportunities and acts as a drain on the SEC’s limited resources.

Second, as the SEC’s thought process on ETFs has evolved over time, it has led to an uneven application of the rules. In some cases, ETFs that were previously approved benefit from investment powers that are not available to new ETF applicants. The SEC decided it had gone too far in granting some firms exemptions to the ’40 Act. For example, the SEC did not approve any actively managed ETF applications for nearly three years. However, the approved ETF Sponsors are grandfathered and are able to continue to launch new products under the relief, which creates a regulatory driven competitive advantage.

Finally, the process creates regulatory uncertainty. At the moment, there are scores of reported applications for new ETFs with the SEC and many of these applications contain significant innovation for the ETF space. The uncertainty of not knowing when (or if) applications will be approved makes it almost impossible for asset managers to enact product strategy.

Mercifully, there is an easy solution to all of this; it is time to revisit the ETF rule. First discussed by the SEC in 2008, the ETF rule is a proposed set of rules governing US ETFs that covers both index tracking and actively managed ETFs. 

Unfortunately, the rule was swept aside by the post financial crises regulatory agenda and remains unfinished. In the seven years since the ETF rule was first proposed, the industry has evolved and the rule needs to be updated. However, bringing clarity to the ETF industry would remove the burden of the application process, allow the SEC to properly focus on the evolving ETF market and level the playing field with a uniform rule set.

Given the explosive growth in the ETF industry since the ETF rule was first proposed, assets in US ETFs have swelled from approximately USD500 billion to USD1.86 trillion. The industry’s piecemeal regulatory status needs to be addressed. ETFs are not an investment fad; they are here to stay. Instead of a patchwork of exemptions, it is time that a true regulatory framework for US ETFs is created.


This publication is provided by Brown Brothers Harriman & Co and its subsidiaries (BBH) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (EEA), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the US Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorised use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorised and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co, registered in the United States and other countries. © Brown Brothers Harriman & Co 2014. All rights reserved.11/2014.

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