Operating Under the ETF Rule: How Are Things Going in the Early Days?

In this episode, which is the fourth in our podcast series focused on ETF issues, Ropes & Gray attorneys Paulita Pike and Ed Baer discuss some of the compliance and board reporting implications of the ETF Rule.

Transcript:

Ed Baer: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Ed Baer, a counsel in the San Francisco office of Ropes & Gray. Joining me is one of my colleagues from the asset management practice group, Paulita Pike, a partner in our Chicago office. In this podcast, which is part of a series of podcasts on ETF issues, we will discuss some of the issues surrounding the implementation of the ETF Rule. The compliance date for the ETF Rule was December 2020, so we are still in the early days, but a number of sponsors have been operating in compliance on the Rule since the middle of last year. Paulita, before we dive into how ETFs are doing in complying with the ETF Rule, can you provide a brief overview of the ETF Rule and the issues ETF issuers have to grapple with under the Rule?

Paulita Pike: Sure. Thank you, Ed. Under the ETF Rule, ETFs have to adopt and implement written policies and procedures that govern the methodologies used by the ETF to construct creation and redemption baskets, and also the process that will be used in the acceptance of baskets. If an ETF intends to use custom baskets, the policies and procedures must also set forth the detailed parameters for the construction and acceptance of custom baskets that are in the best interest of the ETF and its shareholders, and those should include the process for any revisions to or deviation from those parameters. Further to the basket policies, the ETF Rule also includes recordkeeping and disclosure requirements, including pertaining to disclosures on bid-ask spreads, portfolio holdings and premiums and discounts.

Ed Baer: Alright. Do you agree that satisfying the disclosure requirements is a relatively straightforward exercise once a sponsor establishes the requisite data feeds and web pages, while the basket approval process is significantly more complex and involved?

Paulita Pike: Definitely. I think the key and more difficult part here is the basket approval process. The ETF Rule requires that each basket exchanged with an authorized participant or AP be constructed pursuant to the basket construction policy – that would include routine, non-custom baskets. And when custom baskets are involved, the requirements are even more onerous. The policies and procedures must provide the exclusive means for constructing and accepting baskets and for ensuring proper approval of each custom basket that's accepted. Specifically, the Rule requires that the policies and procedures specify detailed parameters for the construction and acceptance of the custom baskets. Also, the policies and procedures have to designate the employees that are responsible for approving custom baskets. So there’s a lot of focus around the process that yields these custom baskets.

Ed Baer: Requiring funds to designate certain individuals and make them explicitly responsible under the Rule. That kind of sounds like the SEC’s go-to approach these days, beginning with the compliance program rule and now it’s the approach for the liquidity rule, the derivatives rule and the ETF Rule. Who are fund sponsors designating to handle custom basket approvals?

Paulita Pike: What we’re seeing from clients is that portfolio managers are the most common choice as designees initially responsible for approving the acceptance and rejection of custom baskets. Which makes a lot of sense because they are the primary interface in that respect, and basket construction and especially the use of custom baskets, is fundamentally a portfolio management exercise. So what we’ve seen in that regard really is not surprising. This is particularly true for fixed income ETFs, where it may not be practical for anybody other than the portfolio manager to negotiate custom baskets for certain asset classes. Beyond that everyday functioning and approval, it’s important for sponsors to establish appropriate monitoring and oversight practices. In that regard, Ed, I wonder if you could tell us what kind of practices you’ve seen from some of the sponsors that you’re working with.

Ed Baer: Sure. To guard against abuses that could exist when ETFs negotiate custom baskets with APs and others, ETF sponsors are carefully monitoring and documenting basket negotiations. And since there's really a lot of freedom with regard to negotiation, many sponsors are relying on the established parameters and reinforcing that the PMs can only accept baskets that are in the best interests of the ETF and its shareholders. Sponsors are also monitoring various metrics to ensure that the APs can not take advantage of the process.

Paulita Pike: All of that makes a lot of sense. Do you have a feel for what else sponsors are doing to monitor the use of these custom baskets?

Ed Baer: Definitely. What we’ve seen is many sponsors use a periodic backward-looking review of the basket creation/redemption process. The ETF Rule requires that an ETF's compliance policies describe the ETF's approach for assessing, including through things like back-testing and other periodic reviews, whether the parameters continue to result in custom baskets that are in the best interest of the ETF and its shareholders. So any backward-looking process should be focused on whether the procedures are working as intended, that is, whether they effectively address the conflicts of interest associated with dealing with the APs, and whether the policies could be improved based on a sponsor's actual experience applying them. From what I’ve seen, these backward-looking tests are being conducted mostly by the compliance team. Paulita, have you seen other types of oversight?

Paulita Pike: Yes. Virtually every sponsor we have heard from has some form of basket oversight committee to conduct the periodic reviews that you’re discussing, Ed. These committees are responsible for evaluating the quality of the custom baskets by looking at data on custom basket usage and performance. In some instances they’re also reviewing situations where a portfolio manager deviates from the custom basket parameters and whether that's disproportionately so with a particular AP. The committees sometimes are also tackling related subjects, for example, whether the transaction fees charged over time have been sufficient to compensate for any trading the ETF has had to do. So a good deal of focus has been placed on this oversight committee or committee structure, and what we have seen implemented largely depends on the particular dynamics of the fund group in question.

Ed Baer: That makes sense, but the ETF board also has a major role to play here. As we’ve seen, it’s important for funds to have a robust set of basket policies and procedures, and a tightly controlled process that reflects the concerns that we have already discussed. But depending on how robust those procedures are, how the internal monitoring and oversight will work, and how the CCO will be involved, it’s possible that board reporting could be lighter rather than heavier. I think it will really depend on what the framework looks like in a particular fund group. What we are seeing primarily is that, as the board gets familiar with custom baskets and these new processes, they and their counsel are expecting more significant reporting as they get more familiar. So Paulita, what type of information have sponsors been providing to the ETF boards in your perspective?

Paulita Pike: I think it’s been a process that has been evolving, Ed. So certainly before the ETF Rule’s compliance date, we saw boards request educational sessions so as to set the stage and be sure they understood what custom baskets are, how they are going to be used, what conflicts or issues may arise with the use of custom baskets, how those conflicts or issues could be addressed by the adviser, and really how all this played into the ETF Rule. And I would say because the Rule just recently went into effect, some boards are still in the process of having those education sessions. Those sessions also have addressed the intersection or the interplay between the ETF Rule with other ‘40 Act rules that the directors are already very familiar with, like the liquidity risk management rule and diversification requirements. Now that the compliance date has passed though, there are a number of boards that are moving into what I would describe as stage two, which involves the receipt of quarterly reports that include information regarding revisions to, or deviations from, the ETF's parameters for the construction and acceptance of custom baskets. The reports also can include explanations for the basis of approving the revisions or deviations from the basket policy, and why the basket was, in the end, in the best interest of the ETF and its shareholders.

Ed Baer: So how are boards receiving this information? Are they getting detailed records or summary reports, or some combination?

Paulita Pike: Well, we have clients that have developed, or that we also have assisted in developing, dashboards for their boards. And the type of dashboard that we’re seeing is one that would show quarter-over-quarter the percentage of baskets that are custom and the type of custom baskets so that trends can rise to the surface and be monitored. For example, a custom basket might be affected for rebalancing purposes, where there are cash substitutions, when the ETF uses representative sampling, etc. So those kinds of reports can highlight the reason for these custom baskets. Some boards also want a dashboard that shows distribution of baskets and custom baskets by AP to determine whether there are patterns of custom basket usage. Where there are patterns, we expect that boards could easily request further reporting to evaluate whether the patterns reflect any problematic activity, for example, attempting to engage in dumping or cherry-picking by the APs. So really the reports that they are either getting or are expected to receive, I would say largely fall into the bucket of “trend reporting” that allows them to know when there might be a topic that may merit further scrutiny.

In addition, boards are also looking at information on things like whether the transaction fees charged on creates and redeems align with the actual transaction costs incurred. And as time passes, we think that boards will be getting reports on things like basket committee operations, back-testing results and certifications that custom baskets were accepted in compliance with the policies and procedures that the board had previously reviewed or approved. We also expect that annual reports of baskets will cover the same topics or similar topics, but instead of those being quarterly, obviously they would be for the full year, and they might actually also include more complex analyses since they would be delivered once a year.

It’s really just the early days of the ETF Rule though, as you noted, and it appears that firms are on the right track. Everybody’s trying to understand how to implement the Rule and then what the reporting implications are with respect to the board. But we do expect that basket policies will continue to adapt as sponsors gain more experience with custom baskets and as boards have evolving tastes and requests. The policies will also change with oversight and testing of the asset management firm, and as that oversight and testing evolves. And everything will probably continue to move here, at least for awhile, until asset management firms and fund groups settle on a set of policies and procedures and reporting framework that works for them.

Ed Baer: Well that brings us to the end of the podcast. Paulita and I want to thank all of you for joining us on this discussion of operating in compliance with the ETF Rule. For more information on the topics that we’ve discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at www.ropesgray.com, where we have links to some additional material regarding these topics. To help you better understand the current ETF landscape, we will be issuing several additional podcasts designed to provide a greater depth of analysis on important and timely ETF issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.