A long-standing regulatory quirk that has favored Wall Street's oldest exchange-traded fund issuers over newer players in the market could soon be resolved.
By September, the SEC is expected to finalize a nearly year-old proposal to repair the patchy regulatory framework that currently controls how asset managers launch ETFs that track everything from emerging market stocks to Silicon Valley's technology giants. The proposal would also allow a broader swath of companies to deploy new ETFs without having to exactly replicate their fund's underlying holdings, usually referred to as the "basket" of securities the ETF depends on. Today, only Wall Street's oldest ETF providers are allowed the flexibility to not mirror a fund's basket, which can be especially useful when the securities are thinly traded bonds.
But if the proposal passes, fund sponsors with an eye for the fixed-income market would have a new license to more easily create bond ETFs, taking the battle between active and passive investment management deeper into the bond market.
"This is really rectifying what has been an inherent unfairness in the market since the '90s," said Dave Nadig, managing director of Cboe Global Markets Inc.-owned news and data provider ETF.com, in an interview. "People who got in early got very broad latitude to do whatever the heck they wanted with their baskets, and people who got in late didn't."
Over the past 25 years, ETFs have become some of the most popular products for mom-and-pop retirees, life insurance giants and all investors in between. These highly tax-efficient products provide their holders with broad market exposure through a single security that trades like a stock but is designed to mimic the performance of an entire index. But the regulatory scaffolding for ETFs has largely gone untouched.
Within its proposal, the SEC suggested permitting a wider array of ETF issuers to use what are known as custom baskets when creating and redeeming shares of their products, as long as they detail the rationale behind the decision and meet a handful of other criteria. The move would address the "unlevel playing field" that has persisted in the ETF industry for years, according to Shelly Antoniewicz, senior director of industry and financial analysis at the Investment Company Institute, or ICI.
The select group of ETF issuers currently benefiting from the flexibility, lower costs and better liquidity of custom baskets include BlackRock Inc. and Vanguard Group Inc. Those issuers are widely considered to operate at an advantage over the likes of JPMorgan Asset Management, Charles Schwab Corp. and Franklin Templeton, which are among a sizable cohort of ETF issuers largely restricted from using more flexible basket structures.
An ETF basket that exactly matches the number of shares it references often "may not be feasible" for ETFs that track less liquid securities such as corporate bonds, BlackRock wrote in a 2018 comment letter where it aired its support of widening the use of custom baskets. For example, the Bloomberg Barclays U.S. Aggregate Bond Index included 10,113 securities as of Sept. 7, 2018, BlackRock wrote. A custom basket could give the issuer flexibility to not match each and every bond.
"Bond ETFs that have custom baskets offer lower bid-ask spreads, even after we control for the age and size of the ETF," ICI's Antoniewicz said in an interview.
By allowing more asset managers into the club, the SEC could open the floodgates for new fixed-income ETFs at a time when investors continue to pour money into such products. Between 2014 and 2018, investors funneled $689.54 billion into passively managed taxable and municipal bond open-end funds and ETFs, more than double the $266.94 billion of inflows into similar actively managed funds, according to data from Morningstar Direct.
ETF issuers that have been restricted from using custom baskets will likely be "dancing in the streets" once the SEC provides more companies with the added leeway, Morningstar Director of Global ETF and Passive Strategies Ben Johnson said. But Johnson said he is skeptical that the limited use of custom baskets to date has actually deterred issuers from launching new products.
"There are fixed-income ETFs covering virtually every segment of global markets you could imagine," Johnson said in an interview. "It's a fairly full menu."
Still, issuers are already preparing for the finalized rule.
Many clients of London Stock Exchange Group PLC-owned index provider FTSE Russell already know what "lane" within the fixed-income market they want to pursue, if and when custom baskets can be broadly used, according to Kristen Mierzwa, the index provider's managing director of ETP strategy and business development.
"We have clients who have been holding off on going into the fixed-income world, waiting to see if they can do custom baskets," Mierzwa said in an interview. "There's a lot of room for them to grow."