A Deep Dive on New ETF Liquidity Rules By Dave Nadig, Director of Exchange Traded Funds, FactSet
When the SEC published draft rules for mutual fund and ETF liquidity last year, I was less than complimentary. I pointed out that, for instance, virtually all corporate and high yield bond ETFs would fail to meet the requirements on illiquid assets. That rule is sailing through (with some small changes) for Mutual Funds, but the press is reporting that ETFs got a pass.
ETF Liquidity Rules – Some Background
The original proposal–which is basically going through on October 14–says that no more than 15% of a fund can be in securities that cannot be liquidated in seven days without difficulty. That standard remains vague and up to the issuer to determine, although the SEC did change the wording slightly to “reasonable expectations based on current market conditions” when deciding if a specific security can be dumped without impact.
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If the fund crosses the threshold, it triggers a requirement to notify the fund board, and starts a 30 day remediation clock, after which the board has to essentially re-assert that the liquidity management plan isn’t bogus. In practice, this puts the liability on the fund board, which means you can bet that essentially every fund will comply once they trigger the 15% hurdle.
This will definitely have an impact on a whole swath of traditional mutual funds, anywhere a fund is focused on illiquid assets like, say, junk bonds or microcaps. It will also have a disproportionate impact on large funds vs. small funds, and I predict that one of the workarounds we may see from fund companies is fracturing large funds into multiple smaller funds, whose positions could then meet the requirements–certainly not the intent of the law.
ETF Liquidity Rules – What About the ETF Get-Out-of-Jail-Free Card?
The SEC has defined for the first time a class of ETFs they refer to as “In Kind ETFs.” In Kind ETFs are those that use only a de minimis amount of cash in any creation and redemption activity. The commission goes out of its way to say that they really mean this: if you regularly use cash redemptions, you’re not covered here. The second big issue is that in order to qualify you must publish you complete portfolio every single day – the same transparency standard the SEC has so far held actively managed ETFs to.
So what’s the big deal? Well, there are two groups that have an immediate problem. The first is fixed income ETFs. Many, many fixed income ETFs regularly use cash creations and redemptions. Interestingly, it’s redemptions that are called out here, so theoretically, funds that commonly use cash creates can likely continue to do so, as long as they restrict themselves to doing in-kind redemptions.
The effect of that change could mean wider discounts on bond ETFs in down markets, as it puts the burden of illiquid positions firmly in the hands of Authorized Participants. This simply transfers the illiquidity of the underlying to the ETF price, which is likely the intended objective here.
The second big deal here is a doozy, but only for one firm. The vast majority of ETFs on the marketplace currently disclose their portfolios daily. Except one: Vanguard. Vanguard’s ETFs are share classes of mutual funds. As such, they report quarterly portfolios like most mutual funds. My assumption is that the root fund is what will have to make the test, not each individual share class. Is that a big deal? It’s hard to tell. Because of the share class structure, the core funds underneath the ETFs are often massive, which can be an issue for meeting the 15% rule.
On the other hand, most of Vanguard’s 70 ETFs are in highly liquid corners of the market. Still, it’s possible that funds like Vanguard Small Cap (VB), or Vanguard’s Short Term Corporate Bond (VCSH) could face real hurdles. When I ran the volume numbers on VCSH holdings last year, I estimated that even swamping the market, it would take VCSH 16 days to trade out. So without market impact, that’s probably a multiple. Clearly a fund that won’t be in compliance.
Could Vanguard solve this problem? It would be tricky. It would need to spin the ETFs out and adopt full disclosure. That’s a lot of work to save a few funds. Then again, I’m not sure what the options are.
In the end, it does seem like ETFs dodged a bullet here, and while many mutual fund managers will have to start the painful process of both reconfiguring their funds and complying with new rules (which go into effect December 1, 2018). Ironically, the end result here is probably driving more folks to fully-transparent, tax-efficient ETFs for less liquid underlying securities. That puts ETFs firmly in the role of price discovery vehicles, which is where they belong.
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ETF Liquidity Rules