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Streamlining ETF Regulation

The SEC’s proposal would make more data available to investors

Since the launch of the first U.S. exchange-traded fund in 1993, ETFs today total $3.7 trillion in assets and represent 17% of all registered fund assets in the U.S., according to data from Morningstar Direct.

In mid-2017, an estimated 6 percent of U.S. households held ETFs. ETFs have now become retail accessible, forming the building blocks for portfolios created by robo-advisors such as Betterment and Acorns, for individuals saving as little as a few hundred dollars a year. Institutional investors use ETFs to gain exposure to a variety of assets in a cost-efficient way and provide an alternative to derivatives in hedging and diversification.

ETF regulation has lacked legal standardization

Despite their prevalence and retail accessibility, ETFs have lacked legal standardization in the way that mutual funds have. Until the SEC’s proposal on ETF regulation in June, ETFs have had the unusual status of being filed as an exemption from the Investment Company Act of 1940. This means that every fund sponsor who wants to launch an ETF series has to prepare a lengthy application describing that ETF, which is reviewed by the SEC on an individual basis. That makes it difficult for investors to easily compare these funds’ finer points, because each fund series is governed by an individual SEC order granting particular exemptive relief for that series. The SEC has issued over 300 such orders since the launch of the first ETF.

The benefits of ETFs lie in the fact that they are a hybrid product

Like open-end mutual funds, ETFs have the ability to continuously offer their shares for sale. Like closed-end funds, they are traded on secondary markets. Because individuals don’t purchase and redeem directly from the fund, but rather authorized participants conduct creations and redemptions in large blocks, ETFs can often be offered at a lower cost than mutual funds. These benefits make them appealing to retail portfolios and necessitates that ETF regulations improve the quality of data available to investors.

How the proposed ETF regulation could increase data transparency

Under the new SEC proposal, most ETFs could launch without applying for such exemptive relief, giving the market the predictability and confidence that their widespread use demands.

As a condition of launching without first seeking exemptive relief, ETFs will have to make more information available, such as their historic premiums and bid-ask spreads, on the fund sponsor websites. We at Morningstar believe that this information will be crucial for investors to better monitor the effectiveness of funds’ arbitrage process and compare them on the basis of factors such as their liquidity. We hope that as commissioners finalize ETF regulations, the SEC will consider our recommendations to collect data in a structured and consistent format, so that investors can compare ETFs in a more timely and effective way.

The proposed legal process will allow asset managers to launch new ETF products more quickly, have more certainty around the timing of launch, and obtain information more easily about existing products in the marketplace. These benefits will allow asset managers to use ETFs more effectively in the portfolios they manage. The greater availability of data will allow financial advisers to better assist their clients in choosing the appropriate ETF products for their needs. The SEC’s movement toward more defined ETF regulation is a promising step in addressing the current gap in information and legal standardization.

Read more insights from Morningstar’s policy research team.
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