At an open meeting held June 28, 2018, the SEC voted unanimously to propose a new rule codifying exemptions to certain rules under the Investment Company Act. These exemptions have enabled the exchange-traded fund (ETF) industry to grow to more than $3.4 trillion in 24 years. In order to even the playing field for existing ETFs and new entrants to the market, the proposed rule would rescind the existing exemptive orders upon which most ETFs currently operate.
Like mutual funds, ETFs continuously offer their shares for sale. Unlike mutual funds, however, investors in ETFs cannot purchase or redeem individual shares directly with the fund. Instead, “authorized participants” enter into contractual arrangements with an ETF’s distributor to purchase and redeem ETF shares in “creation units.” That is, the authorized participant deposits with the ETF a “basket” of securities and other assets, and the ETF issues a creation unit of ETF shares in return for those assets. The basket is representative of the ETF’s portfolio and is identified by the ETF daily. After purchasing a creation unit, the authorized participant may hold individual ETF shares or sell individual shares to individual investors in secondary market transactions. ETF shares may trade at a premium or at a discount to net asset value, which provides authorized participants with arbitrage opportunities that can help keep the market price of ETF shares close to the fund’s net asset value.
In order to operate in this fashion, ETFs need exemptions from certain rules and sections under the Investment Company Act. Proposed Rule 6c-11 would eliminate the need for most ETFs to obtain individual exemptive relief.
As proposed, Rule 6c-11 would only be available to ETFs organized as open-end funds. ETFs that are organized as unit investment trusts or structured as a share class of a multi-class fund would not be able to rely on the proposed rule. Leveraged or inverse ETFs would also be precluded from relying on the proposed rule. The excluded ETFs would continue to rely on existing exemptive relief.
Under proposed Rule 6c-11, an ETF would be required to provide daily portfolio transparency on its website. ETFs would also be required to disclose information regarding historical premiums and discounts to net asset value and bid-ask spread information. The SEC said that these disclosures are intended to inform investors about the efficiency of an ETF’s arbitrage process.
Under the proposed rule, ETFs would also need to post on their websites information regarding a published basket at the beginning of each business day. ETFs would be permitted to use baskets that do not reflect a pro-rata representation of a fund’s portfolio or that differ from other baskets used in transactions on the same business day (“custom baskets”), provided that such ETFs would be required to adopt written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets. The board of an ETF using custom baskets would be required to find such use to be in the best interests of the ETF and its shareholders.
This is not the first time that the SEC has proposed a rule aimed at codifying the existing exemptive regime for so-called “plain vanilla” ETFs. Rule 6c-11 was first proposed in 2008, but the intervening global financial crisis required the SEC and its staff to refocus attention on rule-making under the Dodd-Frank Act. In the interim, new entrants to the ETF market have had to obtain individual exemptive orders, a process that is both lengthy and costly. Adopting proposed Rule 6c-11 should meaningfully lower the barriers to entry for new entrants to the ETF space.
Comments on proposed Rule 6c-11 will be due 60 days from publication of the proposed rule in the Federal Register.