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).