The Fund Sponsor’s View
Companies looking to enter the ETF market must understand that the unique features of ETFs also put unique requirements on the investment manager from structural, regulatory and operational perspectives.
In the U.S., ETFs are regulated by the Securities and Exchange Commission as registered investment companies, or RICs—the same regulatory structure that governs conventional mutual funds.
A RIC’s primary purpose is to make a profit by investing in securities. They offer investors—with a minimum initial investment—the opportunity to own a diversified portfolio of securities, typically stocks or bonds, run by a professional manager. These highly regulated investment vehicles are governed by the U.S. Investment Company Act of 1940, also called the ‘40 Act.
To operate as an ETF, however, a product must receive “exemptive relief” from certain parts of the ‘40 Act from the SEC prior to commencing operations. Without such relief, a mutual fund cannot trade on a stock exchange—a key feature of ETFs. Similarly, mutual funds are only allowed to trade and conduct transactions with shareholders at their exact net asset value, a rule designed to ensure that investors are treated fairly. But in order to trade on an intraday basis, ETFs require an exemption from this rule as well, and must be allowed to trade on a stock exchange at prices other than the exact net asset value. And because it’s impossible for the fund sponsor to track who owns the shares at any given moment, they cannot provide a prospectus to every investor, another requirement of the ’40 Act.
Receiving exemptive relief from the SEC on these measures is not a simple process, and can take upward of two years. Although the commission is considering ways to streamline the process for “plain vanilla” ETFs, it is currently a significant roadblock for companies looking to “go it alone” in the ETF space. For fund sponsors seeking to do business on non-U.S. exchanges, the regulatory hurdles are substantially different in each market, but no less complex.
Further afield, exchange-traded vehicles (ETVs) that track alternative asset classes by holding futures and options contracts, actual commodities or foreign currencies have different structures. While they are similar to ETFs, they are not strictly RIC funds, and thus they are not regulated by the ‘40 Act. These products are generally structured as grantor trusts, commodity pools or exchange-traded notes. These can come under the regulatory control of other U.S. agencies, such as the Commodities Futures Trading Commission.
ETFs and ETVs also need exemptive relief from various parts of the U.S. Securities and Exchange Act of 1934 in order to allow the creation and redemption process.
No ETF can come to market without these exemptive reliefs in place.
Even after a company gains exemptive relief, launching an ETF can be daunting. As with traditional mutual funds, there are many tasks involved in operating an ETF, many of which are often outsourced to third parties. Creating the right relationships and understanding the roles of each player is key.