In this inaugural episode of our ETF podcast series, Ropes & Gray asset management attorneys Paulita Pike, Jeremy Smith, Brian McCabe, and Ed Baer discuss recent developments in the ETF industry as well as share some insights to help sponsors prepare for the December compliance date for the ETF Rule.
Paulita Pike: Hello and thank you for joining us today on this Ropes & Gray podcast. I'm Paulita Pike, a partner in the Chicago office. Joining me today are several of my colleagues from the asset management practice group, including Jeremy Smith, who's a partner in our New York office, Brian McCabe, a partner in the Boston office, and Ed Baer, a counsel in the San Francisco office. In this podcast, we will cover some recent developments in the ETF world as well as share some insights to help sponsors prepare for the December compliance date for the ETF Rule. I'll now turn it over to Jeremy.
Jeremy Smith: Thanks, Paulita. Let's talk first about Mutual Fund to ETF conversions. When the first active non-transparent ETF application was approved, there was much speculation that fund sponsors would seek to convert existing, traditional open-end funds into ETFs. The potential benefits of such conversions are clear: ETFs are attracting strong in-flows and enjoy substantial investor interests; they offer the prospect of additional tax efficiency; and, under the right circumstances, an existing mutual fund product could provide the hard-to-find initial scale to get a new ETF launched. The challenges to a conversion, or a merger, though real, are not insurmountable. Those challenges include an existing investor base, such as retirement plans, that may not be able to deal with the complexity of holding exchange traded securities that trade at different prices throughout the day; the challenge of dealing with existing shareholders that do not have brokerage accounts set up to hold, and later transact in, ETF shares; consolidating the multiple share classes of open-end funds into a single class of shares that ETFs offer; addressing outstanding fractional shares; and finally, there's also the issue of potentially having to dispose of investment positions that cannot be held under the terms of the exemptive relief applicable to semi- and non-transparent ETFs.
A recent registrant has filed an N-14, evidencing its intent to merge a number of existing open-end funds into newly-formed Shell ETFs, and they've addressed some of the challenges I just noted in ways that we expected. First, they encouraged shareholders to open a brokerage account into which their ETF shares could be deposited. Those investors who fail to open up brokerage accounts are encouraged to exchange into another fund in the complex or redeem their shares prior to the merger, or if they do nothing, they are advised by the N-14 that they will have their ETF shares transferred to a stock transfer agent who will hold their ETF shares until the account owner provides further instruction regarding what to do with the shares. The N-14 states that those holding fractional shares will receive cash in a merger in respect to their fractional shares if the brokers do not support fractional shares. Of note, the N-14 is a combination prospectus and information statement because no shareholder approval is sought in connection with the merger. We suspect, based on the circumstances of a particular conversion or merger, some boards would insist on seeking shareholder approval of a merger or conversion, even if the organizational documents at issue do not require it. All of this is consistent with discussions we had last year with members of the SEC staff charged with thinking about the prospect of such conversions. While the staff thought that there were some interesting issues, including the ones we just noted, they agreed with us that there did not seem to be any insurmountable legal or regulatory issues to mergers or conversions.
We're often asked, however, why we haven't seen more conversions so far. I think there's likely different answers to that question for different sponsors, but I think the answers include: sponsors wanting to launch ETFs that are differentiated from their existing products, an unwillingness of sponsors to put at risk a large, successful existing product, and a conversion may simply complicate the sponsor's arrangements with the financial intermediaries as the economics of an ETF's relationship with the intermediary community can differ significantly in structure from that of a traditional open-end fund, which may offer multiple classes, each with varying servicing and fee arrangements. In one of our next podcasts, we intend to dig a bit deeper into these conversion issues.
Next, I wanted to note the recent launch of a number of active and semi-transparent ETFs. ETFs using models from Precidian, Fidelity, the New York Stock Exchange and T. Rowe Price are now listed and trading. ETFs using the Blue Tractor proxy portfolio model are in the works as well. The upshot of all these launches is that, notwithstanding the novelty of these products and the tough market conditions that recently prevailed, and the lower levels of transparency that these ETF models provide to APs, the bid-ask spreads at which these shares are trading are reasonable for newly-launched U.S. equity ETFs, and the discounts to NAV at which such shares have traded have generally been relatively modest. We think this is an encouraging trend for the products and for product development generally. If these products continue to perform as they have so far, the SEC may be open to further innovation and several sponsors may have their own proposals in the regulatory queue.
In other recent developments, the staff has been busy streamlining the process for bringing semi-transparent ETFs to market. Together with Rule 6c-11, the SEC issued an Exchange Act order that provided '34 Act relief necessary to the operation of ETFs to ETFs that could meet the conditions of Rule 6c-11. Since then, the SEC has extended that relief in the form of a no-action letter. The no-action letter, issued in respect to Fidelity's semi-transparent ETFs, provides relief from the '34 Act necessary to the operation of semi-transparent ETFs. Of note here is that, although the letter isn't entirely clear on the point, based on discussions we've had with the staff, we have confirmed the letter was intended to operate in a manner similar to a class relief letter in that the staff expects other brokers and ETFs to rely on the letter for semi-transparent ETF models that are similar to that of Fidelity's and that can satisfy the conditions of the letter. My colleague, Brian McCabe, is going to tackle some very recent developments arising out of the fund of funds rule, and will then also talk about gearing up for compliance with Rule 6c-11.
Brian McCabe: Thanks, Jeremy. I'm going to start by talking a little bit about the recently adopted fund of funds rule. On October 7, the SEC approved Rule 12d1-4. We're still studying the anticipated impact of that rule on ETFs, but we believe there are a couple of areas of concern. First, the SEC has suggested that ETFs may want to consider asking prospective purchasers whether they're purchasing ETF shares on behalf of investment companies, and documenting that exchange in order to satisfy the ETF's obligation to not knowingly or otherwise dispose of more than 10% of its shares to an investment company. The SEC has also suggested that ETFs might consider adopting policies and procedures to monitor investments by other investment companies. Second, we fear that the rescission of Rule 12d1-2 may make it less likely that funds will routinely invest in ETFs for short-term asset allocation or cash equitization purposes. Because the limitations in the new ETF rule apply not only to folks relying on the rule, but also on fund-of-funds that are structured in reliance on 12(d)(1)(G), we expect that most sponsors will rely on the rule even though this means that they'll have to make additional findings and enter into fund-of-funds agreements because it will allow the fund-of-funds to make investments in other than affiliated funds, including investments in unaffiliated funds and direct investments in securities. Importantly, acquired funds in fund-of-funds structures will now need to limit their investments in ETFs to a new 10% investment bucket for investment companies. Whereas previously, such funds could typically stack their 12d1 exceptive relief on top of Rule 12d1-2, now being rescinded, or the ETF's 12d1 relief also being rescinded without being subject to that 10% limit.
The news isn't all bad for ETFs, however. One positive development is that the rule does clarify that funds that are affiliated persons of an ETF solely by virtue of having 5% ownership stake in an ETF or another fund under common control can make in-kind deposits and redemptions in connection with creation and redemption transactions for ETFs. Our recent alert on fund-of-funds has more details and we expect to issue a podcast shortly that discusses the ETF impacts of the fund-of-funds rule in November.
Now on to the ETF Rule. The mandatory compliance date for the new ETF Rule is December 23, 2020, fast approaching. And by that date, sponsors will need to have adopted policies and procedures, typically based on their existing policies and procedures for exemptive orders, but revised to reflect rule requirements regarding portfolio holdings disclosure, website disclosure, registration statement disclosure, reporting and record keeping, as well as basket policy and procedures. My colleague, Ed Baer, is now going to tell you a little bit more about some of the issues relating to custom baskets. Ed?
Ed Baer: Thanks, Brian. Under the ETF Rule, ETFs have to adopt and implement written policies and procedures that govern the methodologies used by the ETF to construct creation and redemption baskets, and the process that will be used in the acceptance of baskets. If an ETF intends to use custom baskets, the policies and procedures must also set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to or deviations from those parameters. When you're thinking about adopting basket policies, there's a number of general basket construction principles that we think should be taken into account. First, the basket construction methodology should be consistently applied. The policies and procedures should provide the exclusive means for constructing and accepting baskets and for ensuring proper approval of each custom basket that's accepted. No custom basket may be approved that favors an AP or unauthorized participant to the detriment of the ETF and its shareholders. The adviser should have procedures in place to monitor all creation and redemption transactions to ensure that there's no dumping (which means allowing an AP to contribute to the fund certain unfavorable or undesirable securities), no cherry picking (which is when you allow the AP to select desirable securities and take them from the fund), or other inappropriate differential treatment of authorized participants. No basket should be constructed in a manner that allows an AP, a market maker or another market participant to leverage their relationship with the ETF in a way that would adversely affect the ETF. Further, no third party with a pecuniary incentive should influence the selection of custom basket instruments, so that's something that needs to be carefully monitored. As mentioned, the adviser should consistently apply the standards to each AP, each market maker and each market participant with which is engaging in these transactions.
Next, I'm going to talk about custom basket parameters. The Rule requires policies and procedures to specify detailed parameters for the construction and acceptance of custom baskets. In the release that adopted the Rule, the SEC indicated that the policies and procedures could address the requirements for different types of custom baskets differently, and the examples they provided were things like cash versus security substitutions, whether the custom basket is for a creation or redemption, meaning you could have a different type of basket for each. The requirements for different types of ETFs also may differ, such as index versus active ETFs, equity versus fixed income ETFs, and ETFs that invest in domestic versus foreign securities.
When approving custom baskets, the adviser should consider the specific parameters that are included in the policy, and those are things like:
- for index ETFs, the effect on tracking error,
- whether or not the custom basket contributes to the tax efficiency of an ETF,
- the AP's ability to deliver particular securities,
- whether the custom basket assists the ETF in effecting a rebalance or reallocation of the portfolio,
- whether the custom basket assists the ETF in meeting redemption requests, and
- whether the custom basket increases liquidity or diversification of the portfolio.
You should also take into account things such as the impact of other baskets created and redeemed on a particular day – the interaction of different baskets as the trading day goes on. Further, I think it would make sense to also look at whether or not the custom basket is expected to reduce overall transaction costs associated with anticipated or current portfolio rebalancing.
There are some other parameters that you might want to take into account, and those things include:
- the impact on spreads,
- the reduction in overweights and underweights versus an index or benchmark, and
- changes to desired portfolio characteristics such as:
- sector, country, region or industry weightings,
- factor exposures like quality or momentum,
- duration maturity, coupon and other requirements such as that, and
- portfolio liquidity and diversification.
Baskets that include a portion of cash will be typically considered custom baskets, and that often takes place where the AP has a restriction placed on it, such as being unable to transact in certain securities. Other situations where cash may be substituted in lieu of securities include:
- where there's lot sizes for the securities would not be met when dividing up the baskets into various underlying components;
- where there's one or more securities that's not sufficiently liquid or available (which currently happens in the fixed-income market predominantly);
- where, in some markets, the securities themselves are not legally able to be transferred in kind; and
- things, such as TBA mortgage-backed securities, short positions and other positions, that cannot be transferred in kind, and
- finally, if there's a corporate action or some other type of activity with respect to the underlying security.
In all of those situations, it might not be possible or advisable to transfer the security.
We expect, and what we've seen from clients we've talked about this, is that portfolio managers would be the most likely parties that would be monitoring and overseeing the acceptance and rejection of custom baskets. The policies and procedures as mentioned have to designate the employees that are responsible for approving custom baskets, and the SEC suggested strongly that portfolio managers be the parties that would be the most likely candidates for that.
The parameters that we just talked about can be considered and applied differently to different types of ETFs or different baskets for the same ETF as long as the approving employees who are responsible for making a determination as to which parameters are deemed relevant take all of these facts into consideration. In certain circumstances, the approving employees may accept a custom basket that's in the best interest of the ETF and its shareholders when the portfolio manager or the approving employee believes the custom basket will help the ETF achieve its investment objective. What we mean by that is while a custom basket might not meet the exact components or parameters that are set forth in your policy, but the basket would nevertheless be appropriate and in the best interest of shareholders. In those cases, what we're hearing is that the sponsors will be looking to implement additional policies and procedures, require additional documentation and perhaps secondary reviews by third parties, to ensure that those types of transactions are appropriate and defensible and can be documented. Brian's now going to cover some important considerations relating to how you would go about negotiating custom baskets. Brian?
Brian McCabe: To guard against abuses when ETFs negotiate custom baskets with APs and others, some ETF sponsors are carefully monitoring basket negotiations. I think it's important to recognize that the rule doesn't require special oversight of negotiation of custom baskets or, frankly, any oversight of negotiation of baskets. In addition, it may not be practical for anybody other than the PM to negotiate custom baskets for certain asset classes, particularly fixed-income securities where the negotiation of custom baskets can be an inextricable part of portfolio management. And lastly, we've seen some industry participants worrying about who starts the negotiation, whether the APs are going to come with a list of securities they want or whether the PM is going to put out lists of securities they're looking for or want to get rid of. At the end of the day, there's no preference in 6c-11 as to who starts the negotiation, and I don't think that either way is more suspect than the other. So there's really a lot of freedom with regard to negotiation, and although a lot of people have been looking at this closely and thinking about it, in general, I think most folks are taking a fairly hands-off approach to negotiation other than setting up parameters whereby the PMs understand clearly that they're going to have to determine that all the baskets are in the best interests of the ETF, and they can't allow the APs to take advantage of the process. Jeremy's going to talk now a little bit about potential approaches to monitoring the operation of the basket process. Jeremy?
Jeremy Smith: We have discussed the day-to-day basket creation/redemption process, so let's talk about the periodic backward-looking review of the process that will be conducted with the benefit of hindsight. The ETF Rule itself does not require an adviser to review periodically the quality of its custom basket process. However, the final release stated that an ETF's compliance policies should describe the ETF's approach for assessing, including through back-testing or other periodic reviews, whether the parameters continue to result in custom baskets that are in the best interest of the ETF and its shareholders, and should include reasonable controls designed to prevent inappropriate differential treatment among APs. So the purpose of any backward-looking process should be focused on whether the procedures are working as intended, that is, whether they effectively address the conflicts of interest associated with dealing with APs, and whether the policies could be improved based on a sponsor's actual experience applying them.
We're hearing different views in the industry about whether back-testing really adds value. Some in the industry think that the benefits of any back-testing will be extremely limited given that the ETFs will not know on whose behalf each AP will be trading at any particular time. However, we still think it's a process that sponsors would want to implement because it's an area that will attract regulatory attention, and certain patterns of activity may only be identifiable over time.
While many different approaches may work to tackle this subject, because there's a strong analogy here to an adviser's duty of best execution, a firm's best execution oversight committee may be an existing committee well suited to provide this review. The committee could seek to evaluate the quality of custom baskets, by APs, over time and across the complex. The committee could look at data that would tell them if a particular AP requires a higher level of substitutions or cash in their custom baskets, whether the percent of cash in baskets used in redemptions spike during stressed market conditions, what percentage of baskets are negotiated across the complex by AP, and whether baskets of certain APs lead to greater levels of immediate turnover of securities taken into the ETF. The committee could also review situations where a PM deviates from the custom basket parameters and whether that's disproportionately with a particular AP. Higher levels of any of this activity do not necessarily indicate anything untoward. However, we expect it is a type of activity the Staff will expect to get additional scrutiny. The committee could also tackle other related subjects such as whether the transaction fees charged over time have been sufficient to compensate for any trading the ETF has to do. While a number of different approaches would work, something on the order of what I outlined here would provide you a basis to spot favoritism among APs, or at least some activity that might warrant further review. I'll now hand the mic over to Paulita to talk about board reporting and oversight.
Paulita Pike: Thanks, Jeremy. Well, the first step when dealing with a board, of course, is to have a robust set of policies and procedures, and a tightly controlled process, and that -- in fact -- reflects some of the comments that my colleagues have previously made. Depending on how robust those procedures are, how the internal monitoring will work, and how the CCO will be involved, it is possible that the board reporting could be lighter rather than heavier. It really will be dependent on what the framework looks like in a particular fund group. At the beginning, especially as the board gets familiar with custom baskets, they and their counsel will probably want more significant reporting. As we have thought about the type of reporting framework that boards may require, we think it will likely involve a combination of several possible approaches. And, in fact, that is exactly what our experience is reflecting – that different boards and different fund groups use a combination of approaches with respect to board reporting. Most likely, a board will request one or two educational sessions so as to set the stage and be sure they understand what custom baskets are, how they will be used, what conflicts or issues may arise with the use of custom baskets, and how those conflicts or issues will be addressed by the adviser. The educational session could also address how the creation of custom baskets intersects with certain traditional aspects of the '40 Act the directors are already very well versed in, for example, liquidity risk management, concentration limits, and diversification requirements. Boards are also likely to request quarterly reports regarding any revisions to, or deviations from, the ETF's parameters for the construction and acceptance of custom baskets. Those will probably also include an explanation of the basis for approving any revisions or deviations from the basket policy, and why the basket was, in the end, in the best interest of the ETF and its shareholders.
In addition, we have been working with clients who are developing dashboards for their boards. A typical dashboard report shows quarter over quarter the percentage of baskets that are custom and the type of custom baskets so that trends can be monitored – a custom basket might be affected by rebalancing, cash, representative sampling, tax ramifications , etc. Some boards may want a dashboard that shows distribution of baskets and custom baskets by AP. Presumably, there should be some randomness to the distribution of who an ETF is doing trades with and who the custom baskets are going to. But randomness is not absolutely necessary, and so, to the extent the randomness does not exist, it is again likely the boards will request that reports identify, where there is no randomness, why there isn't randomness there. While not strictly related to custom baskets, boards may also want some reporting that shows whether the transaction fees charged on creates and redeems align with actual transaction costs incurred – that might become an annual reporting item. When we think about quarterly reports, we also expect they will include some backtesting results or certifications that custom baskets were in compliance with the policies and procedures that the board reviewed or approved. Annual reports of baskets will likely cover already some of the topics that I've alluded to, but on an annual type of framework so that the board can continue to oversee the aspects of this that a board thinks are important.
That brings us to the end of the podcast. Jeremy, Brian, Ed, and I want to thank all of you for joining us on this summary discussion of recent developments in the ETF landscape. For more information on the topics that we discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at www.ropesgray.com, where we have links to some additional material regarding these topics. And of course, to help you navigate the topics we have discussed on the podcast, we will be issuing several additional podcasts designed to provide a greater depth of analysis to these important and timely issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with any one of us or whomever you already have a relationship at Ropes & Gray. You can also subscribe and listen to the series whenever you regularly listen to podcast, including on Apple, Google, and Spotify. Thank you again for listening.
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