On Wednesday, September 23rd, the SEC proposed new rules that are likely to notably change how mutual funds and ETFs disclose their investments and performance, and even impact decisions about the sizes of positions and funds themselves.
The proposed rules encompass 415 pages, and there will very likely be at least some substantive changes before the new rules are finalized. However, as Dave Nadig, Director of Exchange Traded Funds for FactSet, points out in a September 24th report: "...the SEC tends to get what it wants, so even after the comment period, I imagine some version of these rules will in fact become the law of the land."
Five likely consequences from new SEC rules
Nadig highlights five likely consequences if the new SEC rules are implemented in close to their current form:
1. SEC Rules - More portfolio disclosure
ETFs are very popular because people get to see what they are holding. Knowing what you hold is essential for institutions and sophisticated investors trying to keep a thumb on the pulse of their portfolios. As Nadig points out: "Mutual funds, with their “once a quarter, 30 days delayed” disclosures make that view harder."
While the new rules wouldn’t explicitly change the current set up, funds will be required to report directly to the SEC every month.
Nadig continues to note: "The commission goes out of its way to say that it would only release this data once a quarter, but I believe that’s a ruse—there will be significant pressure from institutional investors to make these monthly reports available, and once one investor has access, funds will be required to send it to everyone. The “easy” route will simply be full disclosure. That’s good for investors."
2. SEC Rules - Big funds lose, small funds win
The new SEC rules implement important changes regarding selling off an entire position held by a fund. The net result of the new rules is that small funds will be better off than large funds when it comes to rapid liquidating of positions.
Nadig offers an example: the iShares Emerging Markets ETF has a 4.1 million share stake in the National Bank of Abu Dhabi, representing 0.05% of its portfolio. Based on FactSet’s Portfolio Analysis tool, it will take eight days to unload that position. However, for a fund that was half EEM’s size, it would take four days. According to Nadig, this "increases the likelihood that funds will have to either close for new money (leading to premiums) or pollute their portfolios with off-index-weight positions."
3. SEC Rules - Trade impact analysis is now a big deal
It turns out Nadig's example under 2 is not really very accurate, because it's simply dividing the average volume by the total position. What the rules actually specify is that funds would have to estimate how long it would take to sell the position without having any impact on the market.
That's not really realistic, so what funds and portfolio analytics and trading partners will likely have to do is come up with solid, justifiable models for how hard it will be to sell a given position. Given the example above, it might actually take iShares as much as a month to unload its whole the Bank of Abu Dhabi position with no market impact.
4. SEC Rules - Junk bonds may be phased out of portfolios
The new rules, however, will make it difficult for funds to hold certain financial classes; how about trying to liquidate large positions in junk bonds or bank loans, for example. When you think about it, the whole premise of these ETFs has been to provide liquid access to illiquid assets. Nadig points out that iShares published a paper a few years ago detailing that ETFs now hold more in bond assets under management than the inventory of the entire corporate dealer market.
Even if you consider trace eligible bonds (the only accurate way to assess any fixed-income liquidity), it doesn't look good.
Nadig offers another example: "In iShares’ enormous iBoxx $ High Yield Corporate Bond ETF, the largest position is a 6% Numerica Group bond, at about 0.5 percent of the portfolio, or $65 million notional. By my calculations, on a good day, that issue trades about $7 million, meaning the single most liquid bond in the portfolio will easily fail the seven-day liquidation rule."
He goes on to argue that the SEC will likely make an exception for some ETFs: "Do I think junk bond funds will be banned? No. I think the SEC will back off and make exceptions for certain single-asset-class ETFs focused on liquidity-challenged sections of the investing landscape. But if I’m wrong, it’s goodnight Irene."
5. SEC Rules - Look for the use of new investment structures
However, there's no need to panic as there is pretty much always some way to work around the problem. One possible solution is to use swaps. ProShares is technically running traditional ’40 Act Mutual funds that hold two assets: cash and swaps. They get away with having one large derivatives position because the real asset is the pile of cash collateral being held against the swaps.
Nadig notes that the same structure could also be used to launch a "clone fund" tracking the same index as the iShares iBoxx $ High Yield Corporate Bond. While it would be relatively inefficient compared to the current structure, where there’s demand, products are typically created.
Another alternative would be exchange-traded notes. Again it's all about demand. Although there's been a big slowdown in ETF issuance as banks have been unwilling to accept the offsetting balance sheet entries on their living wills, that could change if there's profit to be made.