SEC Clarifies ETF Treatment of Creation Baskets During Passive Concentration Exceedances

On July 27, 2026, the staff of the SEC’s Division of Investment Management (the “Staff”) issued a no-action letter (the “Letter”) to the Investment Company Institute (the “ICI”) confirming that the Staff would not recommend enforcement action under Sections 13(a)(3) or 34(b) of the 1940 Act against an ETF that, during a passive exceedance of its disclosed industry concentration policy:

• Accepts a pro rata creation basket including investments in the over-weighted industry,
• Uses cash received in lieu of a creation basket component to purchase that component security up to an amount consistent with a pro rata basket, or
• Receives a non-pro rata creation basket whose industry weighting is consistent with that of a pro rata basket.

The Letter resolves long-standing uncertainty about how ETFs should treat in-kind creation basket activity when experiencing a passive exceedance of a disclosed concentration policy due to market movement. In addition, the Staff confirmed that the Letter applies equally to actively managed and index-based ETFs.

Regulatory Framework. A registered fund, including an ETF, generally may not deviate from its disclosed concentration policy without shareholder approval. Section 34(b) of the 1940 Act separately prohibits any person from making an untrue statement of material fact in any registration statement or other document filed under the statute. These requirements operate to inform shareholders of a fund’s concentration policy and allow them to weigh in on changes to such policy.

The existing guidance from the SEC Staff is that when a passive concentration exceedance exists, a fund may not make further investments in the relevant industry but need not sell down its existing position. However, this guidance was developed in the context of traditional, order-based mutual fund transactions and, therefore, never addressed the unique mechanics of the ETF creation and redemption process in which authorized participants (“APs”) initiate creation orders that increase an ETF’s holdings.

Unlike traditional mutual funds, ETFs issue and redeem shares exclusively in creation units through APs who deliver a “creation basket” of securities and, where applicable, cash-in-lieu, in exchange for a fixed creation unit of ETF shares. SEC guidance limits the circumstances under which an ETF can close to new investment,¹ and an ETF’s manager generally cannot control the timing or occurrence of creation orders. As a result, APs’ creation orders submitted during a passive exceedance may increase the ETF’s gross holdings in the over-weighted industry.

ICI’s Requested Relief. The ICI requested no-action assurance for three specific scenarios arising during a passive exceedance.² First, the ETF accepts a pro rata creation basket that includes investments in the over-weighted industry. The ICI argued that accepting such a basket does not reflect a volitional investment decision. That is, the ETF “scales up” while maintaining the same proportional industry exposure. Therefore, “from the perspective of any individual shareholder, concentration has not increased.” Second, where cash is received in lieu of a basket component representing an investment in the over-weighted industry, the ETF uses that cash to purchase a basket-component security up to an amount consistent with a pro rata basket. The ICI argued this is also non-volitional because the need for cash-in-lieu typically arises from circumstances unrelated to portfolio management (e.g., small lot sizes or restrictions on in-kind transfers). Third, the ETF receives a non-pro rata creation basket where the weighting of the over-weighted industry is consistent with the weighting that would have applied in a pro rata basket. The ICI illustrated this scenario with a hypothetical ETF that had a 26% passive exceedance in the auto industry, which receives a non-pro rata basket that shifts weighting between two healthcare positions without changing overall industry mix. A shareholder would experience an exposure of 26% both before and after the creation order is processed and changes to the weighting of other industry securities are not relevant to how the exceedance is addressed.

The ICI invoked prior Staff precedent recognizing “non-volitional” exceedances of other 1940 Act limitations and argued that requiring an ETF to alter basket composition or substitute assets to cure a passive exceedance could harm shareholders in the manner the SEC has sought to avoid in other contexts. The ICI also underscored that without relief, alternatives such as seeking shareholder approval to amend the ETF’s concentration policy would impose significant costs.

The Staff’s Response. Based on the facts and representations in the ICI’s letter, the Staff stated that it would not recommend enforcement action to the SEC under Sections 13(a)(3) or 34(b) against an ETF that, during a passive exceedance of its disclosed concentration policy with respect to investments in any particular industry or group of industries, takes any of the three actions described above. The Staff expressly confirmed that its no-action position applies equally to actively managed ETFs and index-based ETFs.

Observations

The Letter provides long-sought confirmation for ETF management and creation/redemption operations during periods of passive concentration exceedance, thereby reducing the risk that ETFs must take disruptive or costly action solely in response to market-driven fluctuations outside the ETF adviser’s control. In light of the Letter, ETFs and their advisers should consider:

• Reviewing basket construction and compliance procedures. Where appropriate, basket construction, cash-in-lieu, and portfolio compliance monitoring procedures should be updated to document reliance on the Letter’s three specific scenarios.
• Coordinating across stakeholders. Fund complexes should coordinate with APs, index providers (for index-based ETFs), and portfolio management teams to ensure basket construction methodologies documented in reliance on the Letter are consistently applied and appropriately reflected in AP agreements and operating procedures.
• Reviewing public disclosures and board reporting. While the Letter gives more flexibility to non-concentrated ETFs, fund complexes should confirm that their risk and concentration disclosures in registration statements adequately describe their approach to reliance on the relief.  Fund boards may also request additional clarity and reporting on the implementation of the Letter. 

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If you would like to learn more about the developments in this Alert, please contact your usual Ropes & Gray attorney contacts.