(Bloomberg) -- In 2019, after years of wrangling, U.S. regulators finally overhauled the rules governing exchange-traded funds to make things simpler, fairer and more efficient.
The changes came just in time.
Within months a pandemic was spreading chaos through markets and the investing world. But the $4.9 trillion ETF industry not only survived, it has gone on to thrive -- thanks in no small part to the rules introduced in December.
Known collectively as the ETF rule, the regulations boosted the pipeline by streamlining the approval process for new offerings. Their guidelines on structure have supercharged innovation. Lower disclosure requirements have lured a host of first-time issuers.
“It was a very long time coming,” said Linda Zhang, chief executive officer of Purview Investments. “The rule really modernized the framework for an industry that has been growing exponentially.”
As a result American ETF assets have climbed to a record despite multiple crises this year, from the fastest-ever bear market to historic dislocations in fixed income and even negative oil prices.
Almost one year after it came into force, here’s a closer look at how the ETF rule has reshaped -- and perhaps rescued -- the industry.
Ready to Launch
There was a moment in March when ETF industry growth looked thwarted. Markets were in turmoil, investors were pulling cash out of multiple assets and fund launches ground to a halt.
Yet many firms had already begun the creation of new ETFs thanks the elimination of the need for a special Securities and Exchange Commission order to allow funds to operate. While the virus-fueled volatility caused some firms to temporarily hit the pause button, as evidenced by just 4 new ETFs launching in March, 22 new funds appeared in April, many hoping to catch a market updraft. The year’s explosion of new ETFs had begun.
“Now, you can launch if you’re smaller, it’s faster, you don’t need to spend as much money,” said Eric Balchunas, ETF analyst for Bloomberg Intelligence. “I think we could see a ramp up in ‘indie’ launches,” he said, referring to releases by less well-known issuers.
More than 200 funds have started trading in 2020 so far, about 40 more than at the same time last year, according to data compiled by Bloomberg.
March of the ANTs
Among the debuts is a new kind of fund made possible by the regulatory shift.
Active non-transparent funds, known as ANTs, allow issuers to hide holdings. That paves the way for stock pickers to offer their strategies in an ETF wrapper without the fear of rivals copying plans or front-running trades.
American Century released the first of these in April, followed by T. Rowe Price Group Inc. and Fidelity. And Invesco Ltd. is moving ahead with its own version.
While ANT inflows have been slow to date, industry observers are closely watching performance and expect this breed of fund to grow in popularity as it becomes better established.
For instance, American Century’s Focused Dynamic Growth ETF (FDG) is up 7.2% so far in October, compared with 4.8% for the S&P 500.
“With both existing and first-time ETF managers launching these products and some choosing multiple structures, it’s an exciting microcosm of the ETF market,” said Ryan Sullivan, senior vice president of Brown Brothers Harriman’s global ETF services.
Resistance is Futile
They held out for almost three decades, but the new rules persuaded some reluctant money managers on Wall Street to finally embrace ETFs.
T. Rowe Price and BNY Mellon both entered the market for the first time earlier this year, while Wells Fargo, Federated Investors and Dimensional Fund Advisors may launch their first ETFs in the near future, according to company statements.
“This rule has encouraged traditional mutual fund firms,” Zhang said. “They can come in without going through the lengthy process, and they can offer their active content under an ETF structure.”
According to data compiled by Purview Investments, 15 new ETF issuers and 20 new ETF brands have launched since the new regulations were approved and announced in September 2019.
Meanwhile, the first mutual-to-ETF conversion is currently underway, with Guinness Atkinson Funds seeking to transform three of its offerings. At the same time, Vanguard Group has been converting some holdings to its lower-cost ETFs, structured as a share class within the mutual fund business.
Creative Thinking
The pandemic has altered consumer behavior, with social views shifting on things like environmental, social and governance issues. The rules have allowed the ETF industry to react quickly.
So far this year, 17 ETFs focused on ESG have launched, including from powerhouses BlackRock Inc. and Vanguard Group. There’s also been a boom in products designed to take advantage of the virus-driven tech rally. For example, both Direxion and BlackRock released “work-from-home” funds featuring stocks like Zoom Video Communications Inc. and Oracle Corp.
“Since March, there has been more interest in thematic products,” said David Perlman, an ETF strategist at UBS Global Wealth Management, especially ones “identifying beneficiaries from Covid.”
At the same time, the industry itself has been maturing, and that’s meant issuers pushing into less obvious parts of the market.
Among recent innovations are the first fund tracking collateralized loan obligations, a blank-check ETF and a product that combines the gains of the S&P 500, Nasdaq 100 and Russell 2000 indexes.
New Worries
Still, some warn that the ETF rule may present new problems.
By making it easier to launch a fund, the regulations might have inadvertently increased challenges for small issuers or those without name recognition which were already in a fight for distribution and assets.
“It’s only ratcheted up the competition because now the barriers are lower, and you have this influx of products,” said Jillian DelSignore, principal at Lakefront Advisory.
The changes also permit the use of what’s known as custom baskets, which allow greater flexibility for authorized participants on what assets are added to or removed from a fund. Yet the related disclosure requirements were more relaxed than many in the industry expected -- raising the prospect an ETF may not track its underlying securities in the way an investor expects.
“While ETFs’ sponsors must publish written policies regarding basket construction and maintain information on each basket they trade,” said Ben Johnson, Morningstar’s global director of ETF research, “they do not have to disclose the makeup of those baskets to the public.”
