New ETF ideas may find it easier to wade through the Securities and Exchange Commission’s red tape, but some are concerned about risks associated under new regulatory rules.
The SEC is readying a proposal that will reduce the time needed to approve ETFs and end inconsistencies that have created an uneven playing field. However, some are worried that fund managers may admit substandard securities into existing ETFs for reasons that have nothing to do with what’s best for the underlying portfolio, Bloomberg reports.
Overall, ETF providers are united in their support of this new flexible basket scheme from the SEC. More recent issuers have been forced to a pro-rata slice of their portfolio or are required to only rely on securities they already own when building out an underlying portfolio for their ETFs, but the new rules may allow both new and old ETF issuers to be more flexible in their underlying securities choices.
“The world’s largest asset managers recognize the downside of something like that is far bigger than the upside, but what about a startup?,” Mo Haghbin, head of product at OppenheimerFunds Inc.’s beta solutions business, told Bloomberg. “There’s always a risk that someone does the wrong thing so, ‘How do you mitigate that risk?’ is the right way of thinking about it.”
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Wary observers are concerned that a small ETF issuer might be tempted to accept less-than-ideal securities from authorized participants – the group behind efficient creation and redemptions of ETF shares – in exchange for assets. Additionally, another could be persuaded to deliver more attractive securities from the fund to a broker that it relies on for business in what is known as “dumping” or “cherry picking.”
Controls in Place
“They are concerned about situations where an authorized participant exerts power over an ETF,” Jane Heinrichs, associate general counsel at the Investment Company Institute, an industry association for mutual funds and ETFs, said of the SEC. “But there are enough other belts and suspenders that take care of that. If you show favoritism to one authorized participant, it’s not going to be a long-term game.”
The potential for abuse is limited since any bad behavior would translate into higher tracking errors, which could dissuade investors from investing, and a manager’s compensation is usually tied to how closely an ETF mirrors its underlying index.
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Regulators may also nip this in the bud by introducing measures like requiring ETFs to spell out their policies on flexible baskets.
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