While the staff of the Ontario Securities Commission (OSC) has expressed that the exchange-traded fund (ETF) industry in Canada is doing a good job of regulating itself and they have no immediate plans to introduce any new ETF regulations, there has been a flurry of activity by the Securities and Exchange Commission (SEC) concerning ETFs in the United States.
New U.S. ETF Rule
On September 26, 2019, the SEC voted to adopt a new rule and form amendments that are intended to modernize the regulation of ETFs in the U.S. The new rule, Rule 6c-11 under the Investment Company Act of 1940, as amended (the Rule), codifies previously issued exemptive relief.
According to the SEC, the adoption of the Rule will “facilitate greater competition and innovation in the ETF marketplace, leading to more choice for investors” and will allow ETFs to come to market more quickly without having to apply for individual exemptive relief. The SEC also voted to issue an exemptive order intended to further harmonize related relief for broker-dealers.
To rely on the Rule, an ETF has to comply with certain conditions intended to protect investors, including conditions related to daily portfolio transparency, custom basket policies and procedures, and website disclosure. The Rule will only be available to ETFs organized as open-end funds, which is the common ETF structure. The form amendments are intended to provide more useful ETF-specific information to investors who purchase ETF securities on an exchange.
The Rule, form amendments and related exemptive relief will be published on the SEC’s website and in the Federal Register, and will become effective 60 days after publication. The SEC will rescind those portions of prior ETF exemptive orders that grant relief to the formation and operation of certain ETFs one year after the effective date of the Rule.
The Rule enables ETF operators to more easily bring new products to the U.S. market, without the delay and costs of obtaining individual exemptive relief. The Rule also allows ETF operators to operate on a level playing field under the same restrictions and conditions. The implications of the Rule are expected to result in more ETF operators entering the U.S. marketplace, resulting in more competition and more choice for investors. Though the Rule is unavailable for semi-transparent or non-transparent active ETFs, the Rule may still cause the number of actively managed ETFs in the U.S. to increase due to the relative ease and cost savings of launching an ETF.
In Canada, we have seen a sharp rise in the launch of active ETFs in the last few years. It remains to be seen whether the Canadian regulators will take another look at the portfolio disclosure rules that apply to active ETFs in Canada. This is discussed in more detail below.
Semi-Transparent and Non-Transparent ETFs
Actively managed ETFs constitute a substantial portion of the ETF product shelf in Canada. The Canadian active ETF industry is robust, partly due to the ability of portfolio managers to disclose their investment holdings only quarterly rather than daily. This allows portfolio managers to maintain their competitive advantage by safeguarding the confidential nature of their investments, and to mitigate risks of front-running and copy cat funds.
Actively managed ETFs in the U.S. must disclose their investment holdings daily, so there is no protection of the portfolio managers’ underlying investment ideas. This has resulted in active strategies representing only a nominal percentage of the total ETF assets in the U.S., and those active strategies are mostly fixed income products. This may be about to change. On May 20, 2019, the SEC approved the Precidian Investments’ ActiveShares ETF structure, which provides for an actively managed, non-transparent ETF that is not required to disclose what it owns on a daily basis. Precidian Investments expects to receive listing approval and launch the non-transparent ETF(s) by the end of 2019.
This approval has prompted a number of other applications to the SEC to permit the offering of ETF products under a non-transparent or semi-transparent, actively managed structure. Regulatory support for these offerings may instigate active equity managers who want to protect their proprietary investment ideas to enter the ETF market.
As these structures are approved and launched, we expect the ETF market in the U.S. to see a larger share of active ETF mandates, which could have both positive and negative implications for the Canadian ETF industry.
On the positive side, the OSC may be less likely to pursue new policies that would increase the transparency of actively managed ETFs. The Canadian market, however, may lose its appeal to global active managers if they are able to maintain the confidentiality of their investment ideas through a semi-transparent or non-transparent ETF structure and reach a larger investor audience in the U.S. Hopefully, U.S. ETF operators will be incentivized to bring their actively managed ETFs to Canada if processes can be streamlined and made efficient, thereby bringing more innovative investment products and strategies to Canadian investors.
For further information, please contact any of the authors of this Bulletin, or any other member of the BLG’s Investment Management Group.