Bibb Strench, partner at Thompson Hine and co-founder of ETF BILD, provides an attorney’s perspective on Precidian Investments’ newly created ETF structure, ActiveShares, in Crystal Kim’s Barron’s piece, “Fund Firms Got the Active ETFs They Wanted — and Now They’re Mad.”
Since 2014, direct indexing has been thought of as a potential threat over the ETF industry, but only recently has it become more prevalent. Direct indexing has many advantages that have come to the forefront in recent years: enhancements in portfolio construction, tax harvesting and the demand for passive products. Though these are not new ideas, reduction in transaction costs and technology advancements in creating and customizing indexes have led to the cost and operational efficiencies that have produced an increased focus on these products.
The main difference between direct indexing and index funds is that the investors own the underlying shares. This gives them the advantage to take tax losses on underperforming securities in the portfolio. The overall tax advantage of that process versus the tax advantages of ETFs can be argued, but the results might be negligible. However, that tax advantage versus a mutual fund can be as significant as the advantages of ETFs versus mutual funds.
The advances in technology have simplified the direct indexing process. Creating indexes on Excel has been transported to more systemic processes, yielding more sophistication to product development. There have also been operational improvements in delivering trading instructions and rebalancing data.
Direct indexing has become the next disruptive product in the financial services industry. There have been many discussions about innovation in ETFs and the potential loss of it because the industry is so tied to just three firms — iShares, Vanguard and State Street. Maybe direct indexing is not about ETFs but an additional delivery mechanism to provide investors with the access to passive investment strategies. It is also being seen by traditional ETF providers and indexers as a potential new distribution channel.
There will always be investors who do not want to use ETFs for various reasons and may be willing to pay higher fees to have more control of their portfolio or let their trusted advisor have more access through direct indexing. Thus, this new disruptive process might be more of a threat to active mangers than to passive. They carry the same performance risk as an active manager because of potential tax loss, selling at the wrong time and customizing the portfolio by using a smaller sample of securities than the benchmark.
Direct indexing could also become a boon for ETFs. If direct investing is reaching RIAs who are moving out of actively managed products and their first move to passive is direct indexing, then their next move might be into ETFs. There are still large numbers of RIAs who are not well educated in ETFs, but direct indexing may be the vehicle that strikes their curiosity and eventually pushes them into ETFs. Fee structure could be that trigger point. ETFs are still significantly less than a traditional SMA or direct indexing account.
One group that is all in on the direct indexing craze is the indexers themselves. Fees paid to indexers on direct indexing platforms are more robust than what they are receiving from licensing an index to an ETF provider. The challenge is the depth of indexes on these platforms and how to differentiate your index from others. Brand is less of a differentiator, and index construction is highly vetted by the advisors using these platforms. Performance matters.
Direct indexing is the new disruptive process circling the ETF industry, but it just may be more friend than foe.
March 13, 2019
All signs point to the ETF industry searching for its next pivot point. To kick us off in 2018, we saw the continued trajectory toward new equity index ETF products first led by the roll-out of blockchain ETFs. However, this year seems to signal something entirely different as there has been little to no fanfare about new ETF products entering the space. Chatter in the industry has revolved primarily around deals between small ETF issuers and the absence of, or less show of strength by, large ETF issuers. Consolidation and slowing product innovation have been the bellwether signaling the maturity of many industries. Nevertheless, that may not be the case in this industry as recent off-the-record conversations amongst industry participants have centered around new ideas that are being developed by niche players funded by private equity. As seen in February at the annual Inside ETFs conference, the ETF industry seems to have refueled from its long upward journey in 2018 and is preparing to pivot towards a new trajectory that, nonetheless, is still pointed upwards.
Over recent months, several interesting trends have come to light such as the increase in demand for alternative strategies. The shift in the risk profile of the markets that occurred last October is still on the minds of advisors. They have also become more comfortable with these complex strategies. However, the challenge remains to tailor the pitch for these products as simple sells.
Education continues to rise as a hot topic. As much as we as industry professionals feel that ETFs have become increasingly more mainstream, an education void still persists. The existing RIA channel provides limited education; however, it is just too broad with its one-size-fits-all approach to be the optimum education solution. The RIA channel also is inundated with ETF wholesalers from a wide variety of issuers who tell different stories about ETFs. There are many independent advisors who are being reached on a very limited basis or not at all.
Turning to new players in the ETF industry, distribution and access to seed capital remain the biggest barriers to entry for the ETF market. New ETF managers with a single strategy continue to use social media as an outreach platform, which may be good for branding, but it has not proven to be an effective way for raising AUM. A more coordinated strategy including website, digital advertising and research content that all connect in a cohesive structure remains key. Raising capital to launch is one thing, but having capital for marketing and the ability to stretch that capital for a few years until assets roll is an oft-overlooked component to success.
New and small ETF issuers continue to look at increasing the likelihood of success in their launches by attracting a larger amount of seed capital. However, seed capital remains allusive. The days of having just a good idea and then launching it as an ETF are over. Lead market makers need to see a well thought out and executable distribution plan before even thinking about allocating basic seed capital. Having access to a dedicated sales force and the proper budget to support it will help in that process.
Larger asset managers and insurance companies are beginning to enter the ETF market. They have the brand, access to capital and the sales force needed to be successful. Leaders in the space have recently noted that actively managed, transparent ETFs — especially fixed income ETFs — are gaining steam and are a great way for asset managers to get involved in ETFs while bypassing the passive argument. Non-transparent, actively managed ETFs are apparently also on their way, as there has been discussion that is perhaps more hopeful than based on fact, with the SEC’s approval coming sooner rather than later.
The growth trajectory of the ETF industry continues its upward movement. Demand for new strategies; well capitalized and experienced new entrants; new structures like non-transparent, actively managed ETFs and a larger RIA audience in need of education are all making contributions to the continued rise of the ETF industry.
February 1, 2019
Speed of Information – Not ETFs, Algos or HFT
Why when the markets go down or become volatile do people blame ETFs, algorithms and HFT (high-frequency trading) when the real, and perhaps less obvious, culprit is speed of information?
Maybe it is human nature to build up success stories – ETFs – only to tear them down or to attack new technologies like algos and HFT that many people are familiar with but don’t actually understand or have access to.
The recent market volatility is nothing new. We have seen volatility spike in a variety of different markets over the years for various reasons. The market sell-off that started in October is not unusual given that the bull market has been long in the tooth but with relatively stable economic indicators and thoughts of a Fed Chairman being fired. Uncertainty is and will always be the Achilles heel of the markets.
The current market rally started in March of 2009 and has risen close to 300%, but even a healthy market needs to take a breath. It’s been a great, historic run. Maybe so much concern exists because so many of the people involved in the markets today have never witnessed a bear market. They lack a baseline for guidance and thus have a fear of the unknown.
There are real reasons for the markets moving the way they do, and they have always moved that way even before the proliferation of ETFs. While some of the largest ETFs track markets, they are merely access vehicles that provide investors with exposure to the markets and various asset classes. ETFs are not their own asset class. ETFs are not down, the markets are down. They merely reflect that move; they are not the cause.
ETFs help calm market volatility since they can be bought and sold throughout the trading day. This levels volatility as ETF investors can more readily access the market. However, this is very different for mutual funds. Mutual funds are priced only once a day at the 4:00 p.m. NAV price so when you sell your ETF at 10:00 a.m., you receive the 10:00 a.m. price. When you sell your mutual fund at 10:00 a.m., you must wait until the end of the trading day and will receive the 4:00 p.m. price. Markets can move dramatically between 10:00 a.m. and 4:00 p.m., and mutual fund investors shoulder that risk on every trade.
The fact that mutual funds are priced only once a day at 4:00 p.m. is one of the primary reasons markets tend to move so much during the last 30-45 minutes of the trading day. Mutual fund managers who trade the underlying securities owned by the fund send their trade orders in an order type called Market on Close (MOC) orders. A MOC order is a trade that is not executed at the time the trade is made but rather at the closing price on the day of the trade (typically 4:00 p.m.). If the mutual funds are selling their portfolio securities for any number of reasons, including pressure from large redemptions by their shareholders, then the traders need to accommodate those trades and sell enough shares before the close. Thus, there can be big market moves in the last minutes of the trading day. Again, the same is true for when they are buyers, but no one seems to complain about those situations.
Keep in mind that there is close to $18 trillion of mutual fund AUM as compared to nearly $3.5 trillion of ETF AUM. Hard to accept that ETFs impact the markets, especially in comparison to mutual funds given the difference in assets invested and the contrast of pricing mechanisms.
Another advantage of having ETFs trade on exchanges is that the trading in ETFs is mostly in shares of the ETFs and not in the shares of the underlying securities. As a result, ETF trading in most circumstances does not impact the price of a market index like the S&P 500 because market participants are only trading shares of the ETF back and forth, not the shares of the underlying securities. In other words, millions of shares in SPY (the ETF tracking the S&P 500 Index) can trade without buying or selling any shares of any company in the S&P 500 Index. While this might not always be the case for ETFs that track less liquid securities, trading in less liquid securities has always been a market structure issue that is difficult for the regulators to solve. It is not an ETF issue but a markets issue.
HFT, like ETFs, is often targeted for disrupting the markets. However, it isn’t the problem either and like ETFs, it is highly beneficial to markets. Back when there was a floor-based exchange and brokers were the market’s intermediary, they could take anywhere from six cents to 50 cents out of every trade. High frequency traders, one of today’s key intermediaries, trade for fractions of one penny. HFT’s impact on the cost of a trade is negligible versus the liquidity HFT provides. Yes, there are bad actors, but the regulators have caught up to most of them by outlawing many of the order types and practices that were harmful. In fact, the regulators are catching up to technology changes quicker than they ever have.
If not ETFs and high-frequency trading, it must be algorithms that are to blame when markets behave erratically. Not so fast. A lengthy argument can be made that algorithms are just doing what humans have asked them to do. They do not cause the market to move, they just speed up the process. Back in the days before algorithms, the information that traders and investors needed to make decisions was very fractured. The institutional and professional investors had access long before the retail investors ever did. Brokerage houses that had the information called their institutional clients first, mostly with information they received from their hedge fund clients. When markets sold-off or ran higher, retail was last in the pecking order of the information flow. For example, if there was a 20% sell-off in the market, retail investors would not be able to react to it until after the market was down and in some cases, more than 15% down. It might have been an orderly sell-off that took a week or two to filter out, but the retail investor was at a major disadvantage.
Fortunately, regulatory and technology changes came along to level that playing field so information now flows quickly and to all market participants at the same time.
Today, thanks to technology, that “sell signal” is disseminated to everyone at the same time. Thus, everyone is a seller and markets move faster. Some people call it the “herd mentality.” Everyone is now reacting to the markets in the same way because we all have the same information at the same time if we look for it.
The markets aren’t perfect, market structure isn’t perfect. But, we reap the benefits of the most liquid, most regulated and fairest markets in the world despite what the conspiracy theorists say.
A news item, a presidential statement delivered through a Tweet or a geopolitical incident can project uncertainty in the markets and trigger market signals, which will move the markets. ETFs are not to blame and neither are algos or HFT; it’s just the natural order of the markets in today’s digital age. But if you still feel the need to play the blame game, then blame the speed of information.
January 29, 2019
- Many expect the SEC to soon approve newer versions of exemptive relief for the next generation of actively managed ETFs, which differ in how they keep the ETF’s strategy secret, how they support the arbitrage process and potential intellectual property (IP) protection.
- Five applicants have received and responded to SEC comments.
- Potential sponsors of this next generation of ETFs should understand these different models and related IP implications to decide what path they want to follow to be able to offer these ETFs.
Many believe the SEC is poised to allow for the first time the next generation of actively managed ETFs (Next Gen ETFs), which differ from traditional ETFs in that they differ in how they keep the ETF’s strategy secret, how they support the arbitrage process and potential intellectual property (IP) protection, as discussed further below. If the SEC opens the floodgates, the impact on the ETF industry and the asset management space in general will be seismic because of the pent-up demand to offer existing actively managed investment strategies in an ETF wrapper, as evidenced by the dramatic current imbalance between actively managed ETFs (approximately $45.8 billion in AUM) and index ETFs (approximately $3.36 trillion in AUM). A more normal equilibrium between the actively managed and index worlds may in large part be a zero-sum game, with accelerated outflows from mutual funds to ETFs.
Investment advisers should prepare for the advent of Next Gen ETFs by:
- studying, among other things, publicly available SEC exemptive applications and patents of the expected first Next Gen ETFs;
- exploring the possibility of developing their own Next Gen ETF methodologies;
- considering licensing Next Gen ETF methodology as a quicker route to launch such ETFs;
- preparing an application to be filed with the SEC for exemptive relief to launch their own Next Gen ETFs; and
- evaluating how offering Next Gen ETFs that largely clone their actively managed mutual funds will impact their business.
This edition of ETF Reg Insights describes Next Gen ETFs and their current regulatory status and details the five Next Gen ETFs expected to be approved simultaneously by the SEC (First Movers). It concludes with a discussion about what advisers should consider when making business decisions about how to potentially utilize these products.
Status of Next Gen ETFs
An ETF is an investment company registered with the SEC that publicly issues shares representing interests in a pool of securities. Unlike mutual funds, ETF shares trade on a primary market available only to “authorized participants” (APs) and a secondary market (Cboe, Nasdaq and NYSE) available to all investors through their broker-dealers. The price of the ETF shares at any point in time when a secondary market is open is determined by market forces. Thus, there is a bid and ask price throughout the trading day, just like the price of shares of Amazon, Apple and other operating companies. Each morning prior to the opening of the exchange, the ETF posts a list of all of its portfolio holdings (constituents) and its lead market maker sets its opening price.
After the exchange opens on a given day, a discrepancy almost immediately exists between the share price and the net asset value (NAV) per share of the ETF. Depending on the ETF’s size, typical volume of trading and other factors, this spread may be narrow or wide. The lynchpin of the ETF product is that APs (and market makers through APs) have various financial incentives to transact in the primary market to exploit this discrepancy. When the ETF share is trading at a premium of its NAV, an AP can acquire and deliver a basket of securities that replicate the ETF’s constituents, receive shares of the ETF and sell the shares for an aggregate price that exceeds the price it paid for the basket of the ETF’s portfolio constituents. This transaction is called a “creation.” Conversely, when the ETF share is trading at a discount to its NAV, an AP can buy shares of the ETF, redeem those shares from the ETF in exchange for a basket of the ETF’s portfolio constituents, and sell the portfolio constituents for an aggregate price that exceeds the price it paid for the ETF shares. This transaction is called a “redemption” or “redeem.”
As noted, the process can work only if the AP and other market participants know the makeup of the ETF’s portfolio, which the SEC under current ETF exemptive orders requires the ETF to post each day prior to the opening of trading on the market where it is listed. The great barrier obstructing rapid growth of actively managed ETFs has been the SEC’s requirement for such ETFs to disclose their investment portfolios on a daily basis, which potentially allows competitors to backtest their portfolios to determine their investment strategy (the “secret sauce”) or otherwise discern when they are entering or exiting existing positions, both of which create “front running” or “free riding” concerns.
Five financial firms or groups of firms continue attempts to overcome the actively managed ETF barrier by devising acceptable alternatives to the requirement that an actively managed ETF expose its portfolio each trading day. They have developed ETFs that, in lieu of daily exposing their portfolios and the exact security weights, make available enough information to theoretically allow arbitragers to exploit any discrepancy between the ETF’s NAV and share price without disclosing the ETF’s full portfolio to the public. The firms hope that in 2019 the SEC will finally approve the Next Gen ETF product, APs will embrace their models and assets will begin to flow into them.
Next Gen ETF Models
To our knowledge, five Next Gen ETF exemptive applications are pending with the SEC, which have been filed by Blue Tractor, Precidian, Fidelity, Natixis and T. Rowe Price. One of these firms (Precidian) filed a Next Gen ETF proposal with the SEC in 2013 that was withdrawn in 2014 following an SEC notice indicating its intent to deny the application and criticism of the proposed intraday disclosures intended to act as a substitute for daily portfolio holdings disclosure. To address these comments, all of the current pending applications include more refined supplementary forms of intraday disclosures to facilitate arbitrage activities. Variation exists between the Next Gen models in terms of the level of transparency of the actual securities that make up the portfolio composition file (PCF). Since the creation/redemption process can also be a form of information “leakage” about the Next Gen ETF’s portfolio to APs and other market participants, the basket of securities that a Next Gen ETF will accept or deliver in exchange for a creation unit, or the process for a creation or redemption, differs from that of traditional ETFs. The applications for some models assert claimed patent protection on certain aspects of these processes. These aspects of the five pending Next Gen ETF exemptive applications are summarized below.
Models Claiming Patent Protection
Blue Tractor ETF Trust and Blue Tractor Group
Daily disclosures. After the close of trading on day T, an ETF fund (or its custodian) will access a secure cloud software platform called the Blue Tractor Shielded Alpha℠ Service, which generates a portfolio (the Dynamic SSR℠ portfolio) that will be the in-kind creation basket for trading on day T+1. The actual portfolio is never disclosed on a daily basis, only the generated Dynamic SSR portfolio. As per current ETF industry practice, this basket will be published by the NSCC as the Next Gen ETF’s PCF and used by market makers and authorized participants on day T+1 for high-frequency intra-day pricing, hedging, to effect bona fide arbitrage and for in-kind creations and redemptions with the Next Gen ETF. The basket will hold 100% of the actual portfolio securities (and no others), but the portfolio weightings in the basket will differ from the actual portfolio weightings. Importantly, the basket will have a minimum 90% asset value overlap with the actual portfolio. Because the market will know 100% of the portfolio holdings (but not the actual weightings), the applicants in the Blue Tractor Application believe that the structure is more accurately characterized as a substantially transparent ETF and not a non-transparent ETF. At the close of each day’s trading a new basket is generated that will have randomly generated portfolio weightings that always differ from the actual portfolio; it is the daily change in basket weightings that fully obfuscates the Next Gen ETF’s alpha generation strategy
Creation/redemption process. Creations and redemptions will be effected directly by authorized participants with the Next Gen ETF through the in-kind transfer of securities in the Dynamic SSR portfolio. Because of the minimum 90% in asset value overlap between the Next Gen ETF portfolio and the Dynamic SSR portfolio, the Blue Tractor Application states that the in-kind exchange is anticipated to be relatively tax-efficient and low-cost. A cash amount may be required or paid in lieu of certain positions, according to the circumstances described in the Blue Tractor Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
Precidian ETF Trust, Precidian ETF Trust II and Precidian Funds LLC
Daily disclosures. The sponsor disseminates a verified intraday indicative value (VIIV) of the actual Next Gen ETF’s portfolio throughout the trading day. The VIIV will be calculated every second throughout the trading day and on a per-share basis based on the value of the actual securities in the fund’s portfolio, cash and any accrued interest and declared but unpaid dividends, minus accrued liabilities. Using a current VIIV along with existing fund disclosures, APs are expected to do a regression analysis and construct dynamic hedge portfolios to hold shares and arbitrage the difference in the market price/NAV of shares when the opportunity arises.
Creation/redemption process. This model takes an “AP representative structure” approach. Unlike traditional ETF APs that transact directly with the ETF through the distributor or transfer agent, APs for these Next Gen ETFs will need to transact through an “AP representative” that will be privy to the Next Gen ETF’s creation basket but will be contractually required to maintain the confidentiality of the basket’s contents. The AP representative will use a confidential brokerage account on behalf of each AP for this purpose. While creation and redemption transactions with the Next Gen ETF will generally be on an in-kind basis, from the AP’s perspective, because of the interposition of the AP representative, transactions will essentially be made on a cash basis. The AP representative will purchase securities in the basket (in the case of a creation) or liquidate securities transferred from the Next Gen ETF’s custodian (in the case of a redemption).
NYSE/Natixis Advisors, L.P. and Natixis ETF Trust II
Daily disclosures. A Next Gen ETF offered by Natixis would disclose a proxy portfolio (Proxy Portfolio) instead of its actual portfolio, which will be comprised of securities in the Next Gen ETF’s potential universe of portfolio securities and is designed to achieve an end-of-day tracking error of no more than 5% compared to the performance of the Next Gen ETF’s actual portfolio. The Proxy Portfolio will be constructed using the NYSE’s proprietary process that uses a factor analysis of a Next Gen ETF’s actual portfolio. The Proxy Portfolio is designed to be overinclusive and will contain more components than the Next Gen ETF’s actual portfolio. In addition, purchases and sales occurring in the Next Gen ETF’s actual portfolio will not be reflected in the Proxy Portfolio until after a 5- to 15-day lag, and the Proxy Portfolio’s aggregate value on any given trading day will equal the aggregate NAV of the Next Gen ETF’s actual portfolio. Each day before market open, a Next Gen ETF’s Proxy Portfolio will be disclosed on its website, along with the historical tracking error between the ETF’s last published NAV per share and the Proxy Portfolio’s value, on a per-share basis.
Creation/redemption process. Creations and redemptions will be effected primarily through the in-kind transfer of securities in the Proxy Portfolio. A cash amount may be required or paid in lieu of certain positions, according to the circumstances described in the Natixis Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
Models Without Claimed Patent Protection
Fidelity Beach Street Trust, Fidelity Management & Research Company, FMR Co., Inc. and Fidelity Distributors Corporation
Daily disclosures. This model takes a “closed-end structure” approach utilizing a tracking basket to disclose a representative portfolio that can be used to construct a reliable hedge against the securities in the Next Gen ETF’s portfolio (Tracking Basket). The Tracking Basket includes a Next Gen ETF’s most recently disclosed portfolio holdings and representative ETFs. The Fidelity Application states that ETFs included in the Tracking Basket will be limited to 50% of the Tracking Basket’s assets. Fidelity will use a proprietary mathematical process to minimize the deviation between the basket and the actual portfolio of the Next Gen ETF. The Tracking Basket will be reconstituted at least as often as a Next Gen ETF’s portfolio holdings are publicly disclosed but may be rebalanced more frequently at Fidelity’s discretion. Fidelity proposes to monitor the deviation between the Tracking Basket’s performance and the actual portfolio using a 5% threshold, which the Fidelity Application states “will be calculated as the annualized standard deviation of the daily difference between the actual NAV of the Fund and the calculated closing NAV of the Tracking Basket measured over a trailing 90 calendar days.” The indicative NAV of the Tracking Basket will be disseminated every 15 seconds throughout the trading day, and the Tracking Basket will be published daily on a fund’s website prior to commencement of trading.
Creation/redemption process. Creations and redemptions will be effected primarily through the in-kind transfer of securities in the Tracking Basket. A cash amount may be required or paid in lieu of certain positions according to the circumstances described in the Fidelity Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the creation basket exchanged for the creation unit).
T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc.
Daily disclosures. Similar to the Fidelity Application, under this model, a “hedge portfolio” will be disclosed daily for each Next Gen ETF (Hedge Portfolio). There will be an 80% overlap of the securities in the Hedge Portfolio and a Next Gen ETF. In addition, an indicative NAV based on each Next Gen ETF’s actual portfolio will be disclosed at 15-second intervals throughout the trading day. In addition to these disclosures, T. Rowe will provide daily information about the deviation between the Hedge Portfolio and a Next Gen ETF’s actual portfolio. T. Rowe would provide the deviation between the performance of the Next Gen ETF’s NAV and its Hedge Portfolio for the most recent rolling one-year period, which will be calculated using prices as of the end of each relevant trading day (Daily Deviation). T. Rowe would also provide metrics on annual “tracking error” (i.e., the standard deviation of the Daily Deviation between a Next Gen ETF’s NAV performance and that of its Hedge Portfolio) and the percentage of Daily Deviations that exceeded a certain number of basis points over the past year.
Creation/redemption process. Similar to the Fidelity Application, creations and redemptions will be effected primarily through the in-kind transfer of securities in the Hedge Portfolio. A cash amount may be required or paid in lieu of certain positions according to the circumstances described in the T. Rowe Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
To License or Not to License
If an adviser decides that a Next Gen ETF should be in its product lineup, a key follow-on decision will be whether to obtain a license to use the methodology from one of the Next Gen ETF First Movers (assuming one of the sponsors noted above is making some or all of its methodology described in the application available to licensees) or to devise its own methodology that is acceptable to the AP community and meets the requirements of the SEC staff. Potential sponsors should note, however, that novel applications take time to receive SEC approval. Most Next Gen ETF First Movers’ applications have been pending for over two years.
The obvious advantage of licensing the methodology from a First Mover is speed to market. First, it takes time and expense to develop a methodology that will be successful. Second, licensing avoids the risk that a First Mover may claim the firm’s new methodology infringes on its proprietary methodology. Licensing should also shorten the time it takes for an adviser to obtain a Next Gen ETF exemptive order, since the SEC staff will have already signed off on the methodology, which has been the key sticking point so far with the First Movers’ applications. Furthermore, the First Movers have a head start in interacting with APs and market makers, so they are willing to facilitate creations and redemptions utilizing the methodologies.
An obvious potential disadvantage is having to pay a licensing fee. (To the extent the fee is similar to a fee to license an index, it may be neutral from a financial standpoint if a sponsor is contemplating a strategy that could be managed actively or passively through a custom index.) There is also the risk of selecting one First Mover’s methodology when another would have been superior. Licensees should be prepared for license terms that impose obligations, conditions and restrictions, for example, reporting obligations and conditions for sharing information or technology. A license agreement establishes a contractual relationship and can risk later disputes for an alleged breach.
An adviser that licenses Next Gen ETF methodology should pay particularly close attention to the licensing agreement to avoid pitfalls that could have lasting ill effects. Key provisions and possible negotiating points to be aware of for any licensing agreement are listed below, but vary depending on the counterparty and the relationship that is contemplated.
- Term and termination: An adviser may not want to be locked into a methodology too long, but also may not want to give up pricing certainty before a Next Gen ETF hits its break-even point. An adviser should have the right to terminate if regulatory authorities later reject the methodology or if the provider fails to enforce its rights against the adviser’s competitors.
- Patent definition: An adviser must guard against definitions of patent and other IP rights (e.g., “know-how,” “licensed IP”) that are overly broad and potentially preclude contractually the adviser’s attempt to develop its own methodology.
- Nature of patent rights: Where a royalty rate is based in part on patent rights, an adviser should take reasonable steps to ensure that the methodology of interest is actually covered by the patent’s claims and unobvious over prior methodologies.
- Non-compete: An adviser should have the freedom to launch ETFs using its own methodology.
- Infringements: An adviser should have some role or at least rights to information regarding infringement lawsuits that threaten the adviser’s ability to use the methodology.
- Confidentiality: The adviser should have the right to sufficient information about the methodology to facilitate its management of the portfolio securities of the ETF and to be able to share such information with APs that facilitate the creation and redemptions of ETF baskets.
- Indemnification: The indemnity clauses are especially important, including how they relate to infringement actions.
- Rate: An established licensor may have standard, non-negotiable royalty rates. But an adviser should try to negotiate reduced rates for a new methodology. A “most favored nation” clause can be helpful in requiring a licensor to offer the adviser a lower rate if later offered to another licensee.
Developing Proprietary Methodology
Many advisers undoubtedly will develop their own methodologies, primarily to avoid paying a licensing fee to a third party. It is quite possible that they will come up with superior methodologies, which they may potentially want to license.
Going this route likely will require scale, especially to entice APs and other market makers to familiarize themselves with still another Next Gen ETF methodology. Scale may also be necessary because of the expense of not only developing the methodology, but also protecting its intellectual property through patents and possibly defending against an infringement case brought by a Next Gen ETF First Mover. One might expect advisers of large mutual fund complexes who have been on the sidelines or barely on the ETF playing field to be the most likely to develop their own proprietary methodologies. Advisers should keep in mind that meaningful patent protection for many business methodologies has been especially difficult to obtain and enforce since a landmark 2014 decision by the U.S. Supreme Court. Alice Corp. v. CLS Bank International, 573 U.S. 208, 134 S. Ct. 2347. In some cases, copyright and trade secret protection for the underlying software will help protect exclusivity.
Therefore, advisers developing their own proprietary Next Gen ETF methodologies should:
- study the Next Gen ETF First Movers’ patents and develop methodologies that steer clear of key attributes of existing methodologies;
- consider the patentability of their methodologies and apply for patent protection before the methodologies are commercially used or offered for license or publicly disclosed;
- consider copyright and trade secret protection and take the necessary steps to protect and enforce those rights; and
- allow ample time for the SEC to review their exemptive applications setting forth their methodologies and for APs and market makers to understand them.
Other Noteworthy Aspects of the Models
Limitations on Next Gen ETF Portfolio Securities
The current iterations of the Next Gen ETF applications each represent that the Next Gen ETFs will generally be limited to investments in exchange-traded equity securities, depositary receipts and certain other types of exchange-traded instruments (e.g., other ETFs, exchange-traded notes and index futures). Therefore, the first iteration of these products would be limited to equity Next Gen ETFs. In the future, as market participants (particularly APs) gain more trading experience with the various models, the SEC may permit Next Gen ETFs to invest in a broader universe of investments.
Regulation Fair Disclosure
Each application includes compliance with Regulation Fair Disclosure (Reg. FD) as a condition. Currently, ETFs and mutual funds are required to comply with disclosure requirements regarding “selective disclosure of portfolio holdings,” which generally requires them to adopt policies and procedures regarding disclosure of nonpublic information about securities in the fund’s portfolio and disclosure in their registration statements of the parties that have access to such disclosure. Reg. FD generally requires contemporaneous disclosure of material nonpublic information to certain specified persons also be made to the public, unless the recipient is contractually required to keep the information confidential.
Because Next Gen ETFs have the potential to be game-changers in the ETF industry, now is the time for advisers of mutual funds and index ETFs to begin understanding these products and deciding whether Next Gen ETFs should be in their product line. Waiting too long may prove costly because assets can shift quickly, especially to superior products like ETFs. Of course, patience may also be necessary since the SEC to date has not completely signed off on Next Gen ETFs and governmental and regulatory delays may continue to be in vogue in Washington, D.C. in 2019.
FOR MORE INFORMATION
For more information, please contact:
Christopher D. Carlson
Clifton E. McCann
 See Proposed Rule: Exchange-Traded Funds, SEC Rel. No. IC-33140 (June 28, 2018) at nn. 3 and 63 and accompanying text (noting that all ETFs registered with the SEC have $3.4 trillion in assets and there are over 200 actively managed ETFs with approximately $45.8 billion in assets as of the end of 2017, based on estimates from MIDAS, Bloomberg and Morningstar Direct).
 Precidian ETFs Trust, et al., Notice of Application (SEC Rel. No. IC-31300) (Oct. 21, 2014).
 Sixth Amended and Restated Application, Blue Tractor ETF Trust and Blue Tractor Group, LLC (File No. 812-14625) (May 23, 2018), available at https://www.sec.gov/Archives/edgar/data/1668791/000168028918000098/20180523bluetractor40appa.htm(Blue Tractor Application).
 Sixth Amended and Restated Application, Precidian ETFs Trust, Precidian ETF Trust II and Precidian Funds LLC (File No. 812-14405) (filed on May 29, 2018), available at https://www.sec.gov/Archives/edgar/data/1396289/000114420418031427/tv495172_40appa.htm(Precidian Application).
 Precidian Application at 22-23.
 Second Amended and Restated Application, Natixis Advisors, L.P. and Natixis ETF Trust II (File No. 812-14870), available at https://www.sec.gov/Archives/edgar/data/1018331/000119312518323642/d649748d40appa.htm(Natixis Application).
 Third Amended and Restated Application, Fidelity Beach Street Trust, Fidelity Management & Research Company, FMR Co., Inc. and Fidelity Distributors Corporation, available at https://www.sec.gov/Archives/edgar/data/35336/000003531518000198/main.htm(Fidelity Application).
 Third Amended Application, T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc. (File No. 812-14214) (June 18, 2018), available at https://www.sec.gov/Archives/edgar/data/80255/000119312518195397/d206953d40appa.htm(T. Rowe Application).
December 5, 2018
From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.
Recently, ETF BILD sat down to speak with Rick Redding, CEO of the Index Industry Association (IIA). We talked about the state of indexing and various regulatory and business issues. Below is a summary of the highlights from that discussion.
ETF BILD: Will the index industry become regulated?
Redding: Index regulation has already occurred in Europe. The European Parliament approved the Benchmarks Regulation, which is a set of rules governing the use of indexes as benchmarks. This regulation has global implications for index providers, not just ones in Europe. It is possible that a new ETF regulation in the United States may be next. The SEC recently has been sending information requests to ETF sponsors of indexes. Often such requests are a precursor to rules.
ETF BILD: Are the costs of compliance and other factors driving consolidation in the index industry or causing index providers to partner with exchanges, data providers and other types of companies with deep pockets?
Redding: I do not necessarily see a wave of consolidation coming in the index industry. Rather, the alternative is for index providers to partner with companies in related industries. For example, there are many synergies with index providers and financial data providers, so those types of consolidations may make business sense.
ETF BILD: Why have intellectual property rights become important in the index industry?
Redding: Index providers naturally want to protect their intellectual property rights to the index methodology. Without the protection of their intellectual property, no provider would ever create new indexes and that would deprive investors of innovative products and competition. Some asset managers are creating their own indexes instead of licensing indexes from the large index sponsors. If a manager’s self-indexed ETF becomes successful, the methodology behind that index becomes valuable to the manager.
ETF BILD: Will new regulations such as the proposed ETF rule potentially make it more difficult to protect index methodology?
Redding: The more information an arbitrager has about an index that an ETF is tracking, the better it is able to trade the ETF’s shares to exploit any difference between the ETF’s net asset value per share and market price. The SEC emphasized the importance of such arbitragers when it proposed the ETF rule, which conceivably could require the publishing of more information about an ETF’s securities holdings. The SEC recognizes the need to protect the underlying intellectual property but also properly wants to have adequate disclosure of the underlying securities.
ETF BILD: You noted the trend for some asset managers to create their own indexes. Does this create conflict or other issues?
Redding: Managers naturally desire to sponsor ETFs and other products that track indexes that perform well as the performance of a financial product is always a key factor in its ability to attract investors. This creates a temptation for an asset manager to put more weight on designing an index that will perform well and less emphasis on making sure it is a useful benchmark. We have seen some providers of so-called smart beta indexes and products struggle with this issue. IIA believes separating the functions provides the best protection for investors.
ETF BILD: How can these conflicts be addressed?
Redding: Such conflicts can be avoided by separating functions: the product creation for investors, index design and administration. The asset manager licenses with a third party for its index or to design an index.
ETF BILD: More and more ETFs that track complex indexes are being introduced each year. Are these indexes too complicated for investors to understand?
Redding: Indexes with multi-variant methodologies and complex rules certainly are on the rise. It can be more difficult to understand their methodologies and why products that track these indexes would be beneficial to the average investor’s portfolio. Nevertheless, these products can be valuable to certain investors, such as institutional investors, who have the knowledge and experience to understand the products and how they can enhance their portfolios.
Direction of the Index Industry
ETF BILD: Where is the index industry headed, especially in terms of key issues?
Redding: Issues related to indexing fixed-income securities are going to become more important as more ETFs and other financial products seek to track fixed-income indexes. Because bonds do not trade on trading venues like equities do and, in many cases, infrequently trade, there are far greater challenges with valuing the bonds that make up a fixed-income index. Information about certain bonds are not as readily available and investors desire better transparency in how they are valued and priced. As these processes become more transparent, it will be easier to develop indexes that more accurately benchmark various types of bonds.
ETF BILD: Will you see more and more custom indexes?
Redding: I believe so, especially with respect to ESG investing. More and more institutional investors are demanding benchmarks that exclude certain types of securities. For example, they may know that an industrial company in a particular ESG index is a low carbon dioxide producer, but it also employs processes that pollute rivers and streams and has a poor record of diversity. As a solution, such institutional investors could seek out index companies that can design an ESG index with multiple screens tailored to their particular circumstances, beliefs and needs.
October 1, 2018
Via E-mail [rule-comments@SEC.gov]
Mr. Brent J. Fields
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, D.C. 20549-1090
Re: Release Nos. 33-10515 and IC-33140 (File No. S7-15-18): Exchange-Traded Funds; Proposed Rule
Dear Mr. Fields:
Thank you for the opportunity to submit this letter in response to the request for comments contained in the above-captioned release (the “Proposing Release”) whereby the U.S. Securities and Exchange Commission (“Commission”) proposes Rule 6c-11 (“Rule 6c-11”) under the Investment Company Act of 1940, as amended (the “1940 Act”). Rule 6c-11 would permit certain exchange-traded funds (“ETFs”) to operate without an exemptive order, subject to the conditions contained therein.
The ETF BILD (Business Insights & Leadership Discussion) is a forum located at www.etfbild.com with a mission to be the catalyst for discussions on the most pressing issues faced by the business leaders of the exchange traded fund (ETF) industry. The ETF BILD Project is at the intersection of academic research and actionable business leadership. The ETF BILD Project is focused on the business insights, leadership, and discussion of the ETF industry.
PROPOSED RULE 6c-11
ETF BILD commends the Commission, particularly its Division of Investment Management, for proposing a rule that is long overdue and strikes the appropriate balance between sensible regulation of ETFs without burdening one of history’s most successful financial products with unnecessary restrictions. On a basic level, Rule 6c-11 eliminates the need for new entrants in the ETF industry from wasting both their resources to file for exemptive orders and those of the Commission to process such orders. While Rule 6c-11 is largely based on conditions in prior exemptive orders and conditions in Rule 6c-11 as proposed in 2008, the Commission successfully pared back those conditions that are no longer necessary.
We caution the Commission, as we do in certain of our comments, to be sensitive to places in Rule 6c-11 and the Proposing Release that blur the lines between the different industry participants: the adviser/sponsor to the ETF, the Indexer, the stock exchanges that trade ETFs (the “Exchanges”) and the APs/market participants. Each such participant are impacted differently by Rule 6c-11 and each are in a unique position to advance many of the goals of the Rule. In addition, we emphasize that while the Commission should be commended for designing a rule and eliciting comments through questions that focus on the individual investor, it should realize that ETFs are used by a variety of types of investors: long-term investors, short-term investors, arbitrage traders, day traders, mutual funds and ETFs and institutional investors. Our comments reflect that out of this group, protecting the long-term ETF investor is of upmost importance.
We applaud the Commission for maintaining the arbitrage mechanism as the cornerstone of ETF regulation and exercising regulatory restraint by not adding superfluous conditions to a process that has consistently resulted in an ETF’s market price being close to its net asset value per share (“NAV”) since the first ETF launched in 1992. With respect to certain concerns the Commission raised in the Proposing Release about the ETF arbitration process during times of stress, we believe that these concerns should be seen in the context of larger market structure issues. ETFs operate under the rules of corporate equity securities where there is no disclosure during times of stress of whether or not a stock is trading at fair value. As seen in previous market stress conditions, the markets revert back to norm in a manner of seconds or minutes. Proper disclosure on websites of ETF issuers would be difficult to execute and more difficult to be used as an informational portal for investors to obtain that information in real time. We suggest to further protect investors. Exchange rules that govern the halting of stocks be reviewed to include more specific process for ETFs.
In the context of the arbitrage mechanism, the Commission in the Proposing Release asked a number of questions about premiums and discounts of an ETF’s share price to its NAV. The Commission asked when would a premium or discount develop due to a breakdown in the arbitrage mechanism. Breakdowns in the arbitrage mechanism would most often be due to price discovery issues of the underlying securities or inability to transact in the underlying securities. Some ETFs track non-equity assets like commodities and potentially cryptocurrencies. The inability to obtain proper pricing or execute transactions in those markets could cause a breakdown in the arbitrage function.
The Commission also asked whether there are instances where a premium or discount may develop or persist because of transaction costs relating to the ETF’s basket securities. We can foresee circumstance from costs in trading and clearing of international securities and non-equity assets as a potential scenario where transaction costs would be prohibitive. These situations are mostly addressed in the product design of the ETF and approved by the ETF’s Board of Directors (the “ETF Board”) prior to launching the ETF. However, market conditions in other markets occur and could cause pricing issues effecting the arbitrage function.
The Commission followed up with the question regarding how these circumstances can be distinguished from one another. These issues are a function market structure and occur in other contexts. We can look at the example of the closed-end fund structure where premium and discounts persist typically on a daily basis. They are disclosed at the end of day to investors and a prolonged situation over multiple days would be sufficient for long term ETF investors to recognize and react to an ongoing situation in an ETF. Those that occur and correct themselves rarely effect long-term investors. Transactions that occur outside the normal market price can be broken under Exchange rules and those rules need to be reviewed to see how the effects of premium and discounts in ETFs are handled.
The Commission asked whether the arbitrage mechanism contemplated by Rule 6c-11 keeps ETFs’ market prices at or close to NAV under normal market conditions. We would again refer to the rules and practices of closed-end fund issuers for the calculations and dissemination of premium and discounts. We agree that end-of-day dissemination would work for ETFs in the context of long-term investors. If short-term traders/investors need more real time information a market solution to provide that data rather than a regulatory solution should be the answer.
With respect to information regarding intraday changes in portfolio holdings, the Commission asked whether the dissemination of such information should play a larger role when assessing premiums and discounts. Such information may not be necessary for long-term investors; however, since the trading community maybe in need of such information for a more efficient arbitrage function to exist we once again suggest a market solution.
The Commission asked whether it is of value to assess the efficiency of the arbitrage mechanism by comparing the mean/median of the market prices on a given trading day against the end of day NAV or whether it is preferable to compare the mean/median of the market price on a given trading day against an intraday measure of the value of an ETF’s portfolio. This may be too difficult to educate investors on the relevance and calculation of this data. The disclosure of the premium/discount at end of day would eliminate the need to this. We also feel these issues are already being addressed at the ETF Board level. Quarterly review of premium and discounts commonly occurs at the ETF Board level when Boards are monitoring how well the arbitrage process is functioning for a given ETF. Taking the extra step to disclosure premium/discounts on a daily basis would add to investor transparency of this issues and allow ETF Boards to react more quickly if a market dislocation becomes an ongoing problematic situation.
The Commission in the Proposing Release asks whether it should establish requirements for creation unit sizes and/or dollar amounts. Creation unit sizes commonly are 100,000 shares, 50,000 shares and 25,000 shares, with a recent trend towards 25,000 shares. Creation unit size is usually a function of the cost of the basket and discussed with the lead market maker and APs prior to launching the ETF. For example, some small ETF issuers and their lead market makers prefer a smaller creation unit size because it facilitates a greater number of creation transactions and asset growth. It has been at the purview of the ETF issuer and should remain there on a case by case process. Thus, we believe this deserves a market solution rather than a regulatory solution. We therefore believe that the Commission should not regulate creation unit sizes. We further note that the recent trend towards smaller creation unit sizes has not adversely effected the ETF arbitrage mechanism.
Suspending Creations and Redemptions
The Commission asked for input regarding whether an ETF may suspend creations only in limited circumstances. In our view, there may be a variety of reasons to suspend creations and limiting them or impose restrictions to certain activity will not allow for differentiation of the circumstances related to the underlying securities. The liquidity levels of various underlying securities or the suspension of trading in certain securities are the main reason for a majority of creation suspensions. We believe current practices developed in the ETF industry allow for the flexibility needed to address this issue.
Proposed Rule 6c-11 requires an ETF to disclose prominently on its website the portfolio holdings that will form the basis for each calculation of NAV per share. Website disclosure of portfolio holdings has proven to be an effective way to convey an ETF’s portfolio holdings. Accordingly, we agree with this condition and believe current standards and practices are sufficient in this area. However, they could be improved upon.
We urge the Commission to study and ask for industry input on generally how ETF industry information is generated and disseminated. Currently, over 100 advisers to ETFs post on their website ETF basket information. While Form N-1A imposes certain requirements on how such disclosure is made, ETFs vary on how such information is presented, which sometimes making it difficult for website visitors to find such information. Since ETF issuers already are required to send basket information in the form of portfolio composition files (PCFs) via the National Securities Clearing Corporation (“NSCC”) and are published daily through the facilities of the NSCC, it makes more sense for there to be a single industry source where collecting, housing and disseminating such information occurs. Furthermore, small- and medium-sized ETF complexes would achieve costs savings by not having to maintain websites posting such information. We therefore recommend that the Rule 6c-11 website basket disclosure requirement remain in place but that the Commission collaborate with the ETF and the Fintech industries to develop and implement an industry website that contains daily basket information. This solution may take time to evolve. For example, the industry may be able to take advantage of distributed ledger (or blockchain) technology to provide basket and holdings information to APs. This technology also could be used to verify creation and redemption transactions with APs.
Brokerage Commission Costs
Proposed Rule 6c-11 requires new prospectus disclosure that includes, among other disclosure items, a narrative explanation that investors may be subject to brokerage and other fees when buying or selling ETF shares and a new Q&A section designed to provide information about bid-ask spreads and other trading costs. The Q&A also must provide links to the ETF’s website, which must feature an interactive calculator for hypothetical cost-related information.
For a variety of reasons, we believe that this requirement will proved to be onerous to ETF advisers and recommend that the Commission eliminate these disclosure requirements from Rule 6c-11. The type and scope of the disclosure required by the Commission has not been required during the existence of the ETF industry and we are unaware of significant industry problems necessitating such disclosure. Instead, ETF investors have made ETFs one of the most successful products in financial history and reaped billions of dollars of savings in the form of lower fees as compared to other financial products. We also believe that the Commission places too much emphasis in the Proposing Release on comparisons between ETFs and mutual funds. While we recognize that ETF investors may be subject to different costs than mutual fund investors, investors have a variety of investment product choices in addition to these products including separately managed accounts, hedge funds, individual securities and others each with their unique cost structures.
In the Proposing Release, the Commission asked whether Rule 6c-11 should include requirements relating to index-based ETFs with an affiliated index provider. We suggest the Commission should be concerned that these rules do not create a situation where a “regulatory advantage” for affiliated index providers or traditional index providers exists. The index provider, affiliated or non-affiliated, play a significant role in function of a public security and investors need a transparent and consistent process for all indexing operations. Our concern in any rules related to the indexer is to make allowances for the protection of their Intellectual property and the both affiliated and non-affiliated indexers are protected in the same manner.
For the reasons discussed above, we support the SEC’s proposed ETF Rule. If the SEC or its staff have any questions or wish to discuss the comments discussed herein, please contact us at 914.406.6277.
Very truly yours,
ETF BILD LLC
August 27, 2018
ETF BILD was formed to stimulate discussion on the business of ETFs, and recently we had the pleasure of sitting down with three of the earliest innovators in the ETF industry, including our own ETF BILD co-founder John Jacobs, to capture their insights on what inspired them in the early days of ETFs and what is driving current and future innovation in the ETF industry.
Joining us are:
- Bruce Bond – Founder of PowerShares, current President of Innovator ETFs
- John Jacobs – Founder of Nasdaq-100 Index (QQQ), current Distinguished Policy Fellow and Executive Director of Georgetown University
- Lee Kranefuss – Founder of iShares, Founding Partner at The Kranefuss Group, LLC.
ETF BILD: You were one of the early innovators in the ETF industry. What did you see back then as the opportunity? How did you execute on that vision?
When John Southard and I founded PowerShares in 2002, the ETF vehicle was less than 10 years old and all of the ETFs in existence were market-cap weighted. So, while the industry was quite young, we felt there was an opportunity to create better ETFs that weighted their underlying stocks based on investment merit rather than by size. To carry out this vision, we worked closely with the American Stock Exchange to build an “intelligent” index that the first PowerShares Dynamic Market ETF (PWC) would track. We branded the index “the Intellidex” and marketed PowerShares as “leading the Intelligent ETF Revolution.”
Executing a vision like intelligent ETFs took a tremendous amount of education and distribution. In 2002, very few people knew what an ETF was, let alone understood why the ones that currently existed should be improved upon. Launching PowerShares on the heels of the tech bubble helped our cause. By the time we arrived, the Nasdaq-100 ETF (QQQ) was the most actively traded security in the world, but its reputation had been damaged by the rise and fall of several heavily-weighted constituents (technology companies). This clearly illustrated that perhaps market capitalization is not the best measure of a company’s value. It sounds rudimentary now but in 2002, these were fighting words to ETF traditionalists.
Nasdaq looked at the ETF space in 1997, although they were not called ETFs then, as an opportunity to create a Nasdaq-branded financial product to enable Nasdaq to interact directly with individuals, institutional investors and traders. Up until that point, Nasdaq always went through an intermediary, whether it was trying to reach shareholders through Nasdaq-listed companies or trying to attract investors through Nasdaq market makers and market participants. We thought that ETFs would be a unique way to influence investor perceptions about Nasdaq and drive positive awareness and attitude, therefore helping Nasdaq in our competitive positioning. We quickly realized that there was a tremendous financial opportunity as well in the area of index products that could help all Nasdaq businesses and be self-sustaining financially. The Global Information Services (GIS) business at Nasdaq today, which contains indexes, data and analytics, is the most profitable business at Nasdaq, and the same holds true at the LSE Group for their GIS unit, which contains FTSE Russell, data and analytics.
We decided not to license the first ETF (QQQ on the Nasdaq-100 index), but rather we created our own fund company similar to the model that the American Stock Exchange followed to create SPY on the S&P 500 Index. We then undertook a three-pronged approach to growing the business. We built out the legacy index platform and operations group to allow for the creation and dissemination of multiple indexes; we separated index data out from the exchange data feed to create separate entitlements and a business development function to work with product sponsors to judiciously license and create index products across multiple channels to reach investors and traders from the most conservative retail investor to the most sophisticated futures trader.
At the time (1998), I was heading strategy at BGI. We were well aware that the largest institutions (with staff and resources to do the work) had come to realize that they were paying too much to and getting too little from most active managers. Worse yet, when they looked across the portfolio they discovered that having large numbers of active managers led to a net outcome that was awfully close to an index fund but with a lot of work and fees. The managers doing well got cancelled out by the ones doing poorly who held the “other” stocks in the index.
We realized the benefits of low-cost and, in the individual market, highly tax-efficient investments as markets that were severely underpenetrated and undermarketed. As the world’s largest indexer, ETFs made all the sense in the world and let us “break bulk.” We could manage a large central fund, with most investors buying and selling their shares on the secondary market, and we would be running what we always ran: large, relatively static and low-cost index funds.
ETF BILD: How different is the industry today versus your original vision of the industry? What has surprised you the most?
We didn’t necessarily have a grand vision for the ETF industry as a whole when I founded PowerShares. We definitely had a clear vision for our firm, which at the time was to build more intelligent ETFs than what currently existed. In terms of brand strategy, you can either be the biggest and the best “something,” or you can innovate, subvert a category and create a new way of thinking. This is what we were doing through PowerShares: increasing people’s perception of what the ETF could actually deliver. iShares, Vanguard and State Street had all but tied up the passive ETF space. We had to create an entirely new category of ETFs and own that new space if we were going to compete with the big three. Looking back, I think we were successful. The PowerShares Dynamic Market ETF (PWC) can be viewed as the cornerstone of the smart beta ETF space, which has seen tremendous growth since its humble beginnings in 2002.
Along those lines, I think what has surprised me the most is the phenomenal growth and proliferation of the smart beta ETF space. In 2002, I never imagined the space would top U.S. $1 trillion, which it did at the end of 2017. I think it shows that investors are still seeking cheaper alternatives to active management in a more methodical way.
The industry has become dominated by a handful of mega-indexers and mega-sponsors today. Although not necessarily surprising, it happened relatively quickly. The concern here is that it may be harder to innovate and get new products to market. In addition, the changes in market structure at the exchanges (primarily in the U.S.) has been a big, behind-the-scenes change for the industry. The end of the specialist system, although very good from an overall market liquidity, quality and competitive standpoint, also ended the most stable supply of new product seed capital. The specialist system did allow for a larger seed capital commitment by market participants in exchange for a monopoly on trading.
We launched 40 funds to start. We believed the market, which includes institutional uses such as traders who need to hedge, funds that needed to equitize cash, etc., needed the basic slices from the big providers. For example, for both Russell and S&P we wanted to offer every slice of U.S. large-, mid- and small-cap as well as growth and value cuts of each. We also saw the need for sectors and international exposure at the country, region and development level (e.g., emerging vs. frontier markets).
We saw ETFs as a better index fund that gave you pinpoint precision. We thought that we would learn from customers and come up with maybe 100 ETFs over time.
What we did not foresee, which I think is a case of turning wine back into grapes in many cases, was the attempt to keep trying to make ETFs more “active.” Suddenly, there were lots of products claiming to outperform the index fund based on some proprietary selection or trading strategy (and at a higher cost). I think the thousands of ETFs out there now – many trying to claim to be active in some way – undermines the key benefits: broad, diversified exposure, low-cost and highly tax-efficient building blocks.
ETF BILD: Where do you see the opportunity in today’s industry?
To me, the opportunity will come through two channels: innovation and regulation. We were fortunate to be part of leading several ETF innovations early on (e.g., smart beta, fixed income, active, commodity). Since those days, we have seen tremendous asset growth but also a high level of product proliferation. Most of these products fit into one of the aforementioned categories. I think some of the larger passive products will continue to see growth; however, we have seen many product launches fail to garner assets and subsequently close due to lack of demand. To me, if ETF issuers are going to succeed in today’s proliferated market, their products have to be innovative and either serve investors’ unmet needs or make things easier and/or lower cost for them.
We are still in early innings in the index investing space. For example, ETFs have yet to penetrate defined contribution platforms such as 401K’s and 529’s in any meaningful way. In addition, actively managed ETFs still make up a small part of the overall market. Although equity ETFs have a very robust offering, other asset classes such as fixed income lag primarily due to the liquidity challenges of the underlying assets because of market and product structure. Niche, innovative index product sponsors have tremendous opportunity to create products that don’t fit the models of the mega-firms.
First, a back-to-basics approach. The gold standard should be a traditional index and then other offerings can be compared to it on all dimensions: cost, tax-efficiency and consistent performance over the long run.
Second, I think there are ideas and approaches that do make sense to augment what was known in 2000. Factors, for example, are a realistic and reasonable idea for the modern world.
ETF BILD: What is the next innovation in the industry that you are working on or that you expect to see?
The ETF is an efficient vehicle that can be used to provide investors with a better overall investment experience and disrupt traditional markets along the way. One innovation I am open to discussing is the concept of replicating a structured note payoff within an ETF. The structured note space is massive (nearly $1 trillion in the U.S. alone), and we think it’s ripe for disruption. We have worked with several leading companies to build a series of ETFs that afford investors defined exposures to the S&P 500 Price Index where the downside protection level, upside growth potential, enhancement level and outcome period are all predetermined. The first two in this series of “defined outcome” ETFs – the Innovator S&P 500 Power Buffer ETF (PJUL) and Innovator S&P 500 Ultra Buffer ETF (UJUL), which were listed on the Cboe on August 8, 2018.
I think the next round of innovation will occur at the product level to try to solve the twin problems of lack of seed capital and the challenge of creating a liquid ETF on illiquid underlying constituents.
Personally, I am working on a book and an internet app that tries to help people step back from staring at the bark and see the forest. Investing is really about meeting your long-term needs after costs, taxes and inflation. My goal is a simple-to-use, free tool for investors that lets them focus on a basic savings and investment plan (assuming to start, low-cost and tax-efficient ETFs) to see if their savings and spending plan have any hope of carrying them through retirement. The rest are seeking better performance, worrying about big market swing years and trying to catch the brass ring by buying hot stocks, or funds, that can be tested later to see if they work, especially after tax.
ETF BILD: What is the biggest concern you have in the industry today that you would like to see change?
Historically, the investment landscape has suffered and has been held back from a type of “pay-to-play” where certain institutions seek to protect less efficient products. You see this quite often in the retirement space where mutual funds and insurance products have historically dominated. I think the ETF vehicle could bring a lot more efficiency to people’s retirement savings, and I would love to see that happen.
My biggest concern is that since Reg NMS was implemented, the markets have been primarily built on speed, speed, speed. That works great if you are QQQ or Apple, but less liquid products and companies don’t reap the same benefit from that market structure. There is no one single market structure that can optimally serve all types of financial products and issuers. I would love to see market segments that have differing market structures that are best suited for an issuer at any particular stage of their life. This would be an issuer choice and they would have the freedom to change market segments as their needs changed.
Far too many ETFs. People took a great delivery vehicle for an investment thesis with huge amounts of empirical justification and institutional adoption and turned it into a marketing tool for their little-know investment idea. They are riding the coattails of ETF success but selling sizzle, not steak.
ETF BILD: What is your vision for the industry 20 years from now?
The ETF structure is still in its infancy relative to other investment products. I do not attempt to predict the future, but I do try and shape it through innovation. I can almost guarantee over the next 20 years there will be markets to disrupt and new asset classes to provide access to through the ETF vehicle. If I made one prediction it would be that we see a continued decline in mutual funds and more asset flows going into ETFs. That seems like a safe bet but to me, by keeping our attention locked in the present and with an eye toward the future, the next 20 years will essentially write itself.
In 20 years, I foresee that the ETF industry will still be booming, the leading edge of financial product innovation and the key to investment and trading strategies for retail investors, institutional investors and their advisors. ETFs will have penetrated multiple asset classes, product channels and geographic adoption. The industry will be less focused on active vs. passive, since both are critical, and rather look to what product can deliver the investment results desired in the most efficient manner while balancing risk and return.
Products that are tightly integrated with robust tools that shine a critical light on reality. You really don’t need that many funds to build a low-cost, extraordinarily diversified and tax-efficient portfolio. The right tools are the only way I see to cut through the clutter.
May 9, 2018
Dalia Blass, Director of the SEC’s Division of Investment Management, in a recent speech questioned whether the provider of an index used by a single ETF should be registered as an investment adviser under the Investment Advisers Act of 1940.[i] Such indexes are sometimes called “bespoke indexes” because they are built at the request and to the specifications of a single sponsor in contrast to broad-based indexes used by asset managers and investors as benchmarks. Any SEC action on this issue could dramatically impact the burgeoning self-indexing segment of the ETF industry, including by adding another regulatory hurdle for new entrants.
In the early years of the ETF industry, most ETF sponsors licensed indexes from the major index publishers such as Dow Jones and Standard & Poor’s, often incorporating the index name into the ETF’s name. These index providers, as noted by Director Blass in her speech, had and continue to have the option of avoiding adviser registration by availing themselves of the publisher’s exception to the definition of investment adviser in the Advisers Act.
More recently, it has become common for an ETF sponsor to develop or co-develop its own or bespoke indexes that are tracked by its own ETFs (called bespoke ETFs). Such sponsors design or co-design their own indexes and typically outsource the calculation of the indexes to third parties including the major index publishers. The SEC routinely grants exemptive orders allowing such “self-indexing.”
Several reasons exist for the proliferation of bespoke ETFs. The sponsor of a bespoke ETF pays licensing fees to itself instead of a third party. By offering bespoke ETFs, a firm can enter the ETF business without having to register as an investment adviser, earning revenue from the ETFs through licensing fees in lieu of advisory fees. The bespoke model allows the sponsor to tailor the index to its investment approach or thesis or to a strategy that an institutional investor seeks. Many such indexes are narrowly focused and use index methodologies with multiple and nuanced screens, producing an index that is a measuring stick useful to few beyond the sponsor or key investor.
If the SEC were to take the position that only registered advisers may license bespoke indexes to ETFs, many current ETF sponsors would be thrust into regulation as investment advisers, change the indexes their ETFs track to broadly followed third-party indexes or be forced to exit the business because such sponsorship is no longer profitable. Director Blass clearly zeroed in on the status of such sponsors when she pondered what the SEC should make of:
- an index that the provider maintains for only one single fund;
- the index provider taking significant input from the fund’s sponsor or board regarding the creation, composition or rebalancing of that index; and
- the index provider being affiliated with the sponsor.
It remains to be seen how the SEC will act in this area. In her speech, Director Blass indicated that questions surrounding this issue will be asked by the Division’s disclosure staff when first reviewing the registration statements of new bespoke ETFs. A position that a bespoke ETF’s index provider meets the definition of an investment adviser and is not eligible for any exceptions from that definition would close the door to many new ETF industry entrants at the same time that the companies sponsoring the largest ETFs, which are already registered as advisers, are beginning to offer their own self-indexing ETFs. It seems likely that the SEC will address the adviser registration issue in its long-promised ETF rule, which its rulemaking staff is currently drafting. Questions from regulators often lead to more questions: Might the SEC posit whether an ETF that tracks a bespoke ETF is really in fact an index (and thus truly passively managed) based on the determination that the single index provider meets the definition of investment adviser because “it is providing advice” to the ETF? The ETF industry has much riding on the answers to these and other questions.
[i] Dalia Blass, Keynote Address, ICI 2018 Mutual Funds and Investment Management Conference, March 19, 2018 (https://www.sec.gov/news/speech/speech-blass-2018-03-19).
ETF veterans discuss implications of FINRA Rule 5250
April 6, 2018
From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.
Recently, ETF BILD sat down to speak with three prominent veterans in the ETF space to capture their insights on FINRA Rule 5250, Payments for Market Making, and its implications.
Joining us for the discussion:
- Reggie Browne – Senior Managing Director of ETF Trading, Cantor Fitzgerald
- Laura Morrison – SVP, Global Head of Exchange Traded Funds, CBOE Markets
- Jim Toes – President and CEO, Security Trader Association (STA)
Background: FINRA Rule 5250 prohibits market makers who provide quotes and related services to companies that list their securities on stock exchanges from accepting any payments from such companies. Rule 5250 is designed for corporate securities listed by ordinary companies and intends to assure that the market maker acts in an independent capacity when publishing a quotation or making a market in such corporate securities. ETFs are dramatically different from ordinary companies and do not present the same concerns, primarily because their economic returns are derived from the corporate securities they own. The application of the rule to ETFs may be preventing a relationship between the ETF issuer and market maker that otherwise could be highly beneficial to the ETF product and investor.
Currently, FINRA is conducting a general review of its rule book and has asked for comments relating to modernizing Rule 5250, which was adopted prior to the existence of ETFs. The debate is centered on whether or not ETFs should be exempt from this rule.
ETF BILD: What’s your view of FINRA Rule 5250 (Payments for Market Making)?
Browne: I’m an advocate for exempting ETFs from the rule because it solves a couple of problems. The ETF industry, on a global basis, should be harmonized to minimize the use of different practices in different global market centers. Refinement of rules governing the investor experience in ETFs should be an ongoing priority. Reorienting the U.S. so that it looks more like Europe, where ETF sponsors could have a direct relationship with market makers for services rendered, helps ensure there is a level playing field over the services delivered while negating regulatory burdens. The result of a commercial relationship between the market maker and ETF sponsor would most likely improve the investor experience in thinly traded ETFs with measurable, tighter spreads.
Also, I would like to note that in Europe there are no rules written on payments by ETF issuers to market makers; it’s silent. In my view, European regulators should take a stance on the practice to test for conflicts and mandate transparency.
ETF issuers want better outcomes, more control and more say in product delivery and process.
Morrison: I believe that Rule 5250 should apply to corporate equities for good reason because of how prices are discovered for corporate equities but not to ETFs. ETFs are essentially derivatively priced, a process that is very different than the pricing of corporate equities. Currently, ETF issuers can create agreements with market makers in Europe and the results of this engagement have been positive, not for all issuers but for some. We see the value in the ability to do it here in the U.S.
Unfortunately, ETFs have been swept into all equity security rules without consideration for what makes an ETF unique. ETF issuers are asking for the ability to pay market makers. We are suggesting that issuers not be required to enter agreements for each and every product and market maker relationship, but rather giving the issuer the option to “pull this lever” on a case-by-case basis as they deem necessary or appropriate. Also, such ETF issuers could be required to disclose if an arrangement exists but not be required to disclose the dollar amount, length of the arrangement or specific requirements and expectations of the market maker. This would be helpful from a competitive standpoint.
Allowing such payments may result in the market maker being more engaged in their quoting commitments to the ETF product. The issuer’s investment up front could result in improved quote quality and price discovery for the end investor, which in turn may improve the issuer’s ability to attract assets in the ETF product.
Toes: If the rule were reformed, it would address certain existing barriers to entry for market makers in ETFs by enabling those firms to recoup some of the initial costs. Investors would still be protected from the harm that Rule 5250 addresses due to the arbitrage feature of ETFs and other unique attributes of the structure. There should be disclosure about these arrangements, which may cause the industry to become hung up on the amount of transparency and how market makers would react if they are asked to provide too much information around specific payments, but this could be sorted out.
ETF BILD: The ETF industry is relatively small with a lot of competitive issues, so it’s hard for them to sit at the table together. Since the STA is a long-established trade association for individuals who trade equity and listed options, can the ETF industry and the STA work together to achieve common goals?
Toes: Here’s some background on the STA. We are comprised of 20 affiliates in the U.S., major cities with financial hubs, and four affiliates in Canada. We serve the trading community and engage in a variety of events; education, newsletters, open calls and conferences. We are a grass roots organization and spend a lot of time in [Washington] D.C. with the regulators and some legislators. We split time between the Senate Banking Committee, FINRA, U.S. Department of Treasury and the House Financial Services Committee.
It terms of ETFs, while this is a new area for us, we have established relationships with the trading desks and market makers for equities and options at firms who also maintain a presence in ETFs. Thus, we are able to leverage existing relationships to obtain new ones. As ETFs are becoming a more integral part of market making activities, it is incumbent on STA to have an understanding of how they trade and issues impacting them. Rule 5250 is a good place for us to start.
Browne: Yes, I think there is a role for STA representing the viewpoints of their members on issues impacting ETFs such as Rule 5250. ETFs are roughly a third of all volume on the equity exchanges, so it makes sense for them to take up some of these causes. So yes, the STA is a viable venue.
Morrison: Cboe has a close relationship with the STA, and their work with the trading community at large is something we welcome in a vibrant, cooperative marketplace at every level. Functionally speaking, ETFs are a source of huge liquidity and trading activity, and so it makes sense that the STA would offer their opinions on behalf of their members and our customers.
ETF BILD: Two last questions: (1) What’s your overall view on the effect of ETFs in the capital markets system; and (2) Are there risks of having the business be dominated by a few firms worrisome?
Browne: There is enough academic research on the topic about indexing, period. ETFs are only a part of the influence of price discovery and corporate equities. I don’t think there is a need for me to comment further. Those who are misinformed will continue talking about it.
There will be more asset managers launching their own ETFs, just like USAA and others, and an evolution will occur. But the football field-length start that iShares, State Street and Vanguard have is because they were first movers and they have done most of the work for the industry, so it is natural that they should be thriving.
Toes: From a systemic risk perspective, we’re not aware of concerns regarding the concentration or market share of the largest issuers. As we learn more about ETFs, we do see some areas of concern with the Authorized Participant or AP process. Phone calls, emails and other examples of lack of electronic connectivity can cause systemic risks. Go back to the crash in ‘87 when all trades were given via phone calls; electronic trading quickly began developing from that event.
Morrison: As for ETF risk in the capital markets system, more academic study and review is always welcome. This only helps expand on the educational efforts needed to support growth. Like many industries, the 80/20 Rule is also prevalent in the ETF issuer space, but that might not last forever. There are many large asset management firms expanding in the space either by organic growth or acquisition. While the U.S. remains in the lead in terms of ETF AUM and trading, we see a tremendous amount of opportunity for additional growth in our industry globally. Consistent attention by exchanges to proper market structure parameters for ETFs will enable that growth.
ETF BILD: ETF BILD and the organizations represented in these interviews have all sent comment letters to FINRA setting forth reasons as to why ETFs should be exempt from Rule 5250.
There are alternative views. One commenter raised concerns that an exemption for ETFs from Rule 5250 could lead to improper behavior in the market making community. It is that commenter’s belief that lifting the rule for ETFs might distort market forces, increase spreads by the market makers not being compensated, create a pay-to-play environment favoring those with more capital available to make payments and ferment an anti-competitive environment with exclusive arrangements.
ETF BILD believes that the concern about these issues should not prevent Rule 5250 from being relaxed for ETFs. In our view, these concerns can be easily addressed in FINRA’s rulemaking process of exempting ETFs from the rule.
Here is a link to all comment letters: http://www.finra.org/industry/notices/17-41
ETF BILD highly recommends reading all comment letters (they are relatively short) to get a full perspective on the issue. We also welcome all comments and to use ETF BILD’s website, LinkedIn and Twitter accounts to create an open, fair and respectful dialogue.