Modern financial markets are a finely woven tapestry of market makers, investment products and vehicles, and investors with diverse expectations and risk appetites. Holding the whole thing together is a structure of rules and regulations. Altering this intricate weaving is always fraught with risk, and tugging on one thread may unravel another. The Securities and Exchange Commission’s recent liquidity and derivatives rule proposals for mutual funds and ETFs may have set the stage for a major unraveling. The combination of these two proposals, if implemented as currently written, may unintentionally create conditions that would drive investors from ETFs toward riskier and less well-regulated exchange traded notes (ETNs).
As we mentioned in our December 15, 2015 post, SEC Proposes Derivatives Regime for Mutual Funds, ETFs, and BDCs, under the proposal, in order to use derivatives, funds (including ETFs) would be required to comply one of two alternative portfolio limitations designed to limit the amount of leverage the fund may undertake through investment in derivatives to 150%. ETFs that are 200% or 300% leveraged as a result of derivatives in their portfolios would obviously fail to meet this test and be in violation.
As we described in our January 19, 2016 post, Pushback on SEC Liquidity Proposals, the SEC’s proposal on liquidity, if adopted, would require that no more than 15% of a fund’s portfolio be comprised of securities that would take longer than seven days to liquidate without moving the market. In addition, the new proposed rules would require mutual funds and ETFs to implement liquidity risk management programs and enhance disclosures regarding fund liquidity and redemption practices.
Bloomberg analyst Eric Balchunas and Dave Nadig, Director of ETFs at FactSet Research Systems, warn that, if implemented, these proposed liquidity limitations would mean that “every broad corporate and high-yield bond fund and every broad emerging markets fund would be in trouble."
Consequently, the combination of these two rule proposals may put $225 billion worth of ETF assets at risk of being in violation, and unintentionally drive investors away from well-regulated ETFs to other less well-regulated products like ETNs. ETNs are debt notes issued by a bank. When an investor purchases an ETN, the bank promises a certain pattern of return based on what the value of the ETN is linked to. ETNs can be linked to practically anything, like precious metals, commodities, obscure equities, and can employ sophisticated strategies that would be impractical or impossible to make fit into a traditional ETF. ETNs are not funds, but unsecured debt obligations and are merely registered as securities under the Securities Act of 1933. As a result, they do not provide to investors the protections afforded by the Investment Company Act of 1940 as ETFs do, and are inherently riskier than ETFs. ETNs expose investors to vastly greater credit risk than ETFs because, whereas ETFs (even leveraged ETFs) are actually required to hold the bonds or derivatives in their portfolios, ETNs are not required to physically hold anything. That means that a failure of an ETN’s sponsor could leave investors with absolutely nothing at all. In addition, ETNs sometimes have hidden fees a host of different tax treatments and complications not present with ETFs.
There has already been a marked slowdown in ETF issuance as banks have been unwilling to deal with the offsetting balance sheet entries on their living wills. If they are adopted without significant changes to address the problems they pose for ETFs, these two proposals could drive ETFs to the mat while at the same time protecting a whole class of investors far less. While intending to deal with derivatives, leverage, and liquidity in mutual funds, the SEC may have yanked a couple of threads that could unravel the ETF industry.