Market's complexities stand out in comments on ETF rule

The long-awaited (and nearly 300-page long) ETF rule proposal by the U.S. Securities and Exchange Commission initially in June was met by little fanfare or controversy from the fund issuers, retail and institutional investors, and trading firms which encompass this nearly $3.6 trillion product market.

Yet, while the core force of the rule is unassailable — to codify 25 years of patchwork relief from parts of the Investment Company Act of 1940 — disagreement around the edges of procedures, data and disclosure came out loud and clear in 40 industry comment letters submitted to the SEC through mid-November.

"From an investment company regulatory perspective, the rule puts to the side the more unique issues in order to move forward with the relief that is relevant to the most ETFs," said Michael Mundt, partner with Stradley Ronon Stevens & Young in Washington. "But there are fundamental questions about the utility of some of the information that the SEC said issuers would need to disclose or publish on their websites," he said in an interview.

Mr. Mundt, who previously helped spearhead ETF policy at the SEC, pointed to trading spreads and basket-related disclosures, the specific securities that brokers known as authorized participants exchange to create or redeem shares of an exchange-traded fund.

"The proposed rule to require dissemination of trading premiums/discounts to net asset value would also require additional work," said Reginald M. Browne, senior managing director of the ETF group at Cantor Fitzgerald.

"The calculation of NAV currently is not standardized across all asset classes, let alone across ETF sponsors," Mr. Browne said. The ETF business line was recently sold to GTS, the largest designated market maker at the New York Stock Exchange and Mr. Browne will be moving to GTS.

Prior to issuing the final rule, there are several points of contention raised in the comment letters for the SEC staff to iron out. Following are some specifics from key ETF market participants:

Intraday indicative value: On behalf of NYSE Arca, the primary listing venue for the majority of U.S. ETFs, Douglas Yones, head of exchange traded products, argued that the ETFs should continue to release IIVs, which the rule had proposed dropping. This data point provides a real-time estimate of an ETF's value and is most effective when the underlying holdings of the ETF trade simultaneously, mostly U.S. equities, but Mr. Yones noted that fixed income, foreign securities and derivatives-related values needed to be improved. On the other hand, Laura Morrison, global head of exchange-traded products for Cboe Global Markets, supported the rule dropping IIVs.

Classification: On behalf of iShares issuer BlackRock Inc., Samara Cohen, managing director of ETF global markets, agreed with many of the rule's proposals and suggested enhancements to investor information and disclosure. But she closed her letter with an admonition that the SEC be more discreet regarding what can be called an ETF. She called for codifying four types of exchange-traded products to include funds, notes, commodities and "instruments" that would include leveraged or capped products.

Inclusion: The rule, as proposed, would essentially expedite SEC approval for both index-tracking and actively managed ETFs that fully disclose underlying holdings. Leveraged funds, unit investment trusts and funds that take advantage of a master-feeder or multishare class structure would not fall under the proposed rule and would have to rely, as they do now, on specific exemptive relief from the SEC. On behalf of Vanguard Group, Chief Investment Officer Gregory Davis wrote in support of the proposed exclusion of ETFs structured as a share class of a fund, the relief that Vanguard itself relies on for the majority of its offerings, because "it is not a common type of relief typically sought by ETF issuers." On the other hand, Richard Morris, general counsel at ProShare Advisors, which offers mostly leveraged and inverse funds, objected to the exclusion of leveraged and inverse ETFs as "unwarranted and anti-competitive." For years, there has been a de facto moratorium on new issuers in the leveraged product market.

The Mutual Fund Directors Forum, an industry association, moreover suggested that both the share-class structure and leveraged products be included in the proposed rule. BNY Mellon, one of the largest custodians and fund administrators for ETFs, suggested the same.

Trading statistics: The Independent Directors Council, on the other hand, focused its comments on the bid/ask spread information and trading cost calculator that the SEC proposed issuers include on their websites. "This requirement would put an unnecessary burden on ETFs to maintain and disclose data and information that it does not control," wrote Amy Lancellotta, managing director of IDC.

Trading baskets: Several comment letters, including one by the ETF committee of the asset management group of the Securities Industry and Financial Markets Association, argued that "the requirement to post portfolio holding and basket information prior to accepting creation and redemption orders will result in significant operational challenges, particularly for ETFs that invest in non-U.S. securities." Additionally, AMG raised concerns about the required disclosure of basket information and portfolio holdings on retail websites. "The principal consumers of basket information are authorized participants, market makers, and other institutional investors," wrote Timothy W. Cameron, AMG Head for SIFMA. This information is already available to the participants who require it and web disclosure "may be confusing or misleading to retail investors."