SEC’s Interest in Novel ETFs Could Become a ‘Reality Check’

The ETF sandbox may have gotten a little too wild.

The Securities and Exchange Commission announced last week that it will open its doors to public comments on “novel” ETF strategies in order to protect investors and foster innovation. The move is the latest by an agency that has been skeptical of highly leveraged strategies in recent months. The issue may be that the rules that worked well for some ETFs — namely Rule 6c-11, which lets ETFs operate under the ’40 Act without having to apply for exemptive relief — may not work for increasingly complex products.

“When products get too complicated, bad things happen,” said Adam Gana, a securities lawyer for Gana Weinstein. “Rule 6c-11 may be too flexible. It focuses heavily on ETF mechanics, but it does not really answer the harder question, which is: ‘Should every strategy that can technically fit inside the ETF structure be allowed to use that structure?’”

Not So Fast

With global ETF assets recently surpassing $23 trillion, the agency’s action may be a little, well … too little, too late. Either way, it’s still a step in the right direction, said Amrita Nandakumar, president of Vident Asset Management. “The SEC’s review of so-called novel ETFs is a long-overdue reality check for an industry that may have pushed the boundaries of Rule 6c-11 too far,” she said.

Specifically, issuers may have taken advantage of the agency’s 75-day rule, under which a fund’s preliminary filing may contain generic language that the issuer can revise later. After the clock runs out, some providers modify the strategy significantly in the final prospectus, meaning the SEC can’t effectively regulate it until after it has begun trading. “Not only is it worth questioning whether 75 days is enough,” she said, “but also, are we entirely sure that some of these novel ETFs really do fall under [Rule] 6c-11, or should they be categorized differently?”

Nandakumar said some ETF categories that may now attract more agency scrutiny include:

• Private credit funds, which are subject to liquidity risk and price swings.
• Complex crypto strategies, which are costly and subject to closures.
• Single-stock derivatives, which don’t hold actual shares of a company, but instead use financial instruments like swaps to track an underlying stock and are subject to compounding decay.

Product Drift: So, what now? Given the SEC’s current Trump-appointed makeup, Gana doesn’t think there will be any kind of broad ETF rollback. What’s more likely to happen, he said, is that the agency will create a sharper distinction between traditional and “novel” funds, with more liquidity requirements, naming standards and possibly limits on certain products being marketed to retail investors — but that would be an “at best” outcome.

“ETFs began as efficient, transparent vehicles for diversified exposure,” he said. “Now we are seeing products tied to crypto assets, leverage, single-stock leveraged strategies, etc. Some of those may be appropriate. But they are not all the same from an investor-protection standpoint.”

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