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 ETFs are typically funds whose holdings are meant to mimic the
performance of an index. To do that, the SEC has said the securities
used to create shares in most funds must be the same ones as in the
fund’s portfolio unless there was a change in the index the fund
tracks.
But BlackRock, Vanguard and a few others, who were among the first
to apply with the SEC to create ETFs, are allowed greater leeway: if
they need a difficult-to-find security to create shares of their
funds, they are permitted to use a similar security – not
necessarily the same one – in the fund. This greater flexibility
makes it easier and cheaper to run the older funds, and harder for
newer entrants into the market such as Northern Trust, Van Eck
Global and Charles Schwab Corp to compete.
The agency's tentative plan - still in its early stages - would
affect how companies manage their portfolios in illiquid markets,
such as bonds. It may result in allowing the likes of Schwab to
compete better with their older rivals, as well as manage their
existing bond products at a lower cost.
"Regulation should not create an uneven playing field that
disadvantages certain shareholders," said Marie Chandoha, president
and CEO of Charles Schwab Investment Management. "We believe
strongly that steps should be taken to ensure that ETF investors
benefit equally."
 On Monday, officials from the SEC's Division of Investment
Management told ETF executives that they thought they could address
the issue without having to go through a formal rule change,
typically a years-long process, according to six people familiar
with the discussions who asked not to be named because they're not
permitted to speak with the media.
The mechanism by which the SEC could provide that relief is complex.
By not aiming directly at funds, but at the so-called trading
baskets that ETFs are required to use to create and redeem shares,
the SEC could probably effect changes with no-action letters or
having ETF providers apply to amend their exemptive orders with the
SEC to offer ETFs.
The officials, Dalia Blass, assistant chief counsel at the SEC's
Investment Management division, Barry Pershkow, senior special
counsel at the division and David Bartels, an attorney in the
division, also indicated that nothing would likely happen until the
SEC finds a replacement for Norm Champ, the former director of the
investment management division who stepped down in January, sources
said.
The SEC and ICI declined to comment.
BASKET MECHANISM
ETFs, which trade on exchanges like stocks but hold portfolios of
securities like traditional mutual funds, must create and redeem
shares as investors buy and sell them. They do this through the
basket mechanism.
When investors want to buy shares, a middleman, known as an
authorized participant and typically a bank or broker, goes to the
market and buys the securities, which are bundled into "baskets" and
delivered to the ETF provider, who uses the newly purchased
securities to create shares for investors. Conversely, when
investors redeem shares, the authorized participant sells the
securities in the open market.
While portfolio managers add and remove securities from their
portfolios, the baskets can be a back-door way that other securities
can get into a portfolio.
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However, if many investors want to buy shares and there are not
enough securities to create shares, the ETF provider may have to
accept cash until they can find suitable securities.
And if many investors want to sell shares, but there isn't enough
demand in the market to take those securities off the authorized
participant's books, the authorized participant will charge the ETF
provider for that additional risk.
Changing the requirements could cut costs for investors in some
funds significantly.
For example, in April 2013, when investors put in orders to pull 21
percent of Vanguard Long-Term Corporate Bond ETF, it would have cost
the fund at least 0.4 percent extra if it were restricted to the
securities in its underlying index, according to a January 2014
presentation by Vanguard published on the SEC's site.
The change could have the unintended consequence of making ETF firms
susceptible to being bullied by their trading partners, which has
been a concern of the SEC, sources said. The worry is that
authorized participants could force ETF providers to take certain
securities they don't want off their books and into the fund
portfolios. That could cause the funds to underperform.
"They could take on securities that they might not want as a favor
and that's when things get hairy," said Dave Nadig, chief investment
officer at ETF.com.
THE BOND FUND SQUEEZE
The issue has come to a head now because of the growing popularity
of bond ETFs, which almost tripled in assets to $305.5 billion over
the past five years, according to Morningstar.
Meanwhile, bond liquidity has all but dried up for corporate issues
after post-financial crisis regulations forced Wall Street banks to
slash their fixed-income inventories. That puts index-following bond
fund managers in a squeeze, as they are required to keep their funds
as exact mirrors of their indexes and are required to create or
eliminate shares as money flows in and out."The industry has been
complaining bitterly for a decade about the haves-and-have-nots,"
said Nadig at ETF. com. "This is the SEC taking a small step to
address this complaint."
(Reporting by Jessica Toonkel and Ashley Lau in New York. Additional
reporting by Sarah Lynch in Washington. Editing by Linda Stern and
John Pickering.)
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