A Guide for Inside ETFs

The annual trek to sunny South Florida is once again upon the ETF industry; a time to reflect, prognosticate and network with our colleagues at the Inside ETFs Conference. It is an interesting time in the industry; change continues to be the only constant, but it feels like it is developing more rapidly these days. Recent regulatory rulings, fee announcements, consolidation, assets flowing into fixed income products, and perhaps fundamental shifts in operational strategies can all pose challenges for the industry in the coming year.

The big three ETF providers remain in complete control of the assets in the industry but there continues to be sizeable pockets of opportunity for the more niche players. As assets continue to flow into ETFs, there remains a significant amount of revenue opportunity in the not fully developed areas such as the alternative/thematic investment themes.

Issuers need to adapt to take advantage of the many opportunities the changes will bring as they come into focus in 2020. These include the use of technology, applying regulatory easing to their advantage, investors’ need for performance driven products in a changing market environment, and reaching distribution channels digitally to name a few.

The Inside ETFs Conference will showcase many of these points during the impressive panel discussions featuring prominent speakers. However, it’s the conversations in the hallways, at the dinner tables, the cocktail hours, and of course, the hotel pool cabanas that may be more informative.

We anticipate the following to be key topics discussed inside and outside the conference that will influence the decisions we make as industry professionals.

   ETF BILD welcomes all comments and suggestions.

ETF BILD Represented at Industry Conference

At ETF Global’s fall ETP Forum, co-founders John Jacobs and Bibb Strench participated in a panel discussion on regulatory, industry and legal issues in the ETF industry. The discussion included developments surrounding product approval process, custom baskets, nontransparent ETFs, and the SEC’s “ETF Rule.”

ETP Forum is a comprehensive one day program that has been built upon the premise of allowing Advisors & Institutions the opportunity to take a deep dive into the most relevant investment themes this year. ETF Global  (ETFG®) is a leading, independent provider of data, research, investment decision support applications, proprietary risk analytics and investment models for Exchange-Traded-Products.

A full look at the ETF Changing Legal & Compliance Landscape Panel can be found here: https://www.youtube.com/watch?v=-_h1PDMfa3s&feature=emb_title

ETF BILD Participates in Thompson Hine ETF & Alts Conference

ETF BILD Co-Founders Bibb Strench, John Jacobs, Richard Keary, and Justin Meise discussed converting mutual funds to ETFs and its implication on the industry at the Thompson Hine ETF & Alts Conference in New York City on September 18, 2019.

Other conference participants included NYSE, Natixis, JMP Securities, CBOE, and FS Investments.

Regulatory, Operational Headwinds Slowing But Not Stopping ETF Innovation

The recent conversation from the SEC referencing the competitiveness of the ETF industry points a finger at some of the challenges the industry faces but there remains plenty of opportunity. The large firms have scale, thus access to larger concentration of AUM; however, the smaller players have the entrepreneurial spirit and the strength of innovation, which built this industry and continues to live in its DNA. Innovation will keep the upstart ETF managers in this business and give them the potential to thrive.

Interesting products continue to come to the market exploring such investment opportunities as space, crypto, blockchain, robotics, clean energy and others. Advancements in index creation technology are building efficiencies and refinement in the production of dynamic indexes, long/shorts, multi-asset, multi-factor and other innovative strategies. The process in which a manager can launch an ETF today as compared to 5 years is much faster and cheaper.

But product differentiation by itself will not attract assets. Seed capital and distribution continue to haunt these nascent ETF managers in growing AUM.  Finding solutions for these problems plagues the industry. The solutions will not come from the larger ETF providers, but from the nimbler and more inspired firms. They must find a way or languish with missed opportunities.

The SEC Division of Investment Management’s approval of Precidian’s ActiveShares and expected approval of additional non-transparent actively managed structures, should open additional doors of opportunity by making available a product that combines mutual fund actively managed capability with ETF tax efficiencies; in other words, a killer app.  These long-anticipated products will bring new users and issuers to the ETF market.  It won’t be an overnight success but a platform to continue to provide solutions for investors.

Another concept that may occur soon when certain regulatory and operational issues are solved is the conversions of Mutual Funds to ETFs. This is a significant opportunity for the ETF industry; a potential game changer, especially when combined with actively-managed, non-transparent ETFs. ETF BILD is taking a deeper look at this development and will provide an in-depth analysis in upcoming content pieces.

Despite all these exciting industry developments the structural challenges that the SEC is investigating still exist. Market structure for low liquidity products, costs and approval process for access to wire-house distribution channels, systemic risks of concentration in custodians and indexers and seed capital to name a few that need to be addressed.

ETF BILD applauds the SEC’s initiatives, including its new outreach initiative targeted at small and mid-sized mutual fund and ETF sponsors. We believe strongly that the smaller and mid-sized ETF providers need a voice in SEC/FINRA rule making process for ETFs. We are also aware of the challenges of having a government regulatory organization interfere in the competitive landscape of an industry. The big ETF providers (iShares, Vanguard, State Street) built this industry and thus have first mover advantage and were the first to build scale into their operations. They should not be punished for that but there also needs to be a proper environment for growth.

Innovation does not just come in the form of new investing themes but in looking at the challenges the industry faces and to find the solutions the industry needs to keep creating opportunities. There are solutions for these challenges, but they won’t all be discovered by the large ETF providers without the input of the more inventive, entrepreneurial and innovative ETF industry participants.  Those whose businesses are in jeopardy because of the challenges of raising AUM.

Changes to the ETF industry either through regulation or in best practices can ensure that growth opportunities for small and mid-sized fund companies exist is a critical discussion. We welcome all comments and policy suggestions from our readers.

Direct Indexing: ETFs — Friend or Foe

April 2019

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.

Lack of Education, Demand for Alternative Strategies & More: The Next Big Trends in the ETF Industry

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. 

Market Volatility

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.

Preparing for the Next Generation of Actively Managed ETFs

January 29, 2019

Key Notes:

  • 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).[1] 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.[2] 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[3]

Daily disclosuresAfter 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[4]

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.[5] 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[6]

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[7]

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.[8]

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.

Licensing Methodology

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.

Conclusion

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:

Bibb Strench
202.973.2727
Bibb.Strench@ThompsonHine.com

Christopher D. Carlson
202.263.4169
Chris.Carlson@ThompsonHine.com

Clifton E. McCann
202.263.4159
Clifton.McCann@ThompsonHine.com

[1] 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).

[2] Precidian ETFs Trust, et al., Notice of Application (SEC Rel. No. IC-31300) (Oct. 21, 2014).

[3] 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).

[4] 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).

[5] Precidian Application at 22-23.

[6] 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).

[7] 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).

[8] 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).

Interview with Rick Redding of the Index Industry Association

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.

Regulation

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.

Intellectual Property

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.

Data

Self-Indexing Conflicts

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.

Complex Indexes

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.