ETP FORUM HIGHLIGHTS – May 22, 2024, New York

Opening Remarks

The ETF industry has seen significant growth, transforming into a $10 trillion market over the past decade. Active ETFs are the fastest-growing segment, with future focus shifting towards investment outcomes and customization enabled by technology. Climate risk management in portfolios will evolve, with investors focusing on sectors and companies addressing climate adaptation.

Fund Infrastructure Needs

Market makers play a crucial role in providing liquidity in the absence of natural buyers or sellers, ensuring fair and orderly markets. Key considerations for successful ETF launches include understanding pricing mechanisms, managing spreads, and involving market makers early in the process. Designated Liquidity Providers enhance trading experiences on exchanges like Nasdaq.

The Evolving Global ETF Legal Landscape

Recent regulatory developments include the SEC's approval of spot Bitcoin ETFs and ongoing discussions about Ether ETFs. European markets have stricter eligibility rules for ETFs providing crypto exposure. The SEC's Rule 6011 simplifies the creation of ETFs, although certain structures still require exemptive relief.

Exemptive relief is essential because ETFs were not originally created by statute but through specific exemptions granted by the SEC. These exemptions allow ETFs to operate under modified regulatory requirements, accommodating their unique structure and operations that differ from traditional mutual funds and other investment vehicles. Exemptive relief allows the development and launch of innovative ETF products that might otherwise be restricted by existing regulations. Specific exemptions are necessary to enable ETFs to utilize in-kind transactions and other mechanisms that provide tax efficiency and lower costs.

Example:

Vanguard received exemptive relief in 2002 to launch ETFs that operate within a unique structure, allowing them to offer ETF share classes alongside mutual fund share classes, demonstrating the flexibility and innovation facilitated by this process.

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The 18f-4 regime, established by the SEC, requires funds that use derivatives to implement a comprehensive Derivatives Risk Management Program (DRMP). The key components of this program are: (i) risk identification, assessment, and guidelines; (ii) Value-at-Risk (VaR) testing; (iii) perform regular backtesting of the VaR model to verify its accuracy and reliability; (iv) appoint a Derivatives Risk Manager who oversees the implementation and effectiveness of the DRMP; ensure the Risk Manager has a direct and independent line of communication with the fund's board of directors.

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Key pending SEC rules involve swing pricing, liquidity regulations, and advisor outsourcing, potentially impacting ETF operations and compliance.

• The SEC has proposed swing pricing rules, but it is uncertain when these rules will be adopted and enforced. The industry is awaiting further guidance and finalization of the proposal. In summary, the swing pricing proposal aims to protect long-term investors by ensuring that the costs associated with significant investor transactions are borne by those initiating the transactions. This mechanism promotes fairer cost allocation and helps maintain the stability of mutual funds and, potentially, ETFs.

• The SEC has proposed amendments to the liquidity rule governing open-end funds, including mutual funds and ETFs. One significant aspect of these amendments is the explicit classification of loans as 'less liquid' securities, which impacts the portfolio composition of these funds. This means that loans will be categorized in a bucket that represents assets that cannot be readily converted to cash within seven calendar days without significantly affecting their market value. If the proposal is adopted, open-end funds, including ETFs, will be prohibited from holding loans in proportions that exceed 15% of their net assets. This aligns with existing regulations that limit a fund's investment in illiquid assets to no more than 15% of its net assets. If adopted, funds will need to adjust their portfolios and enhance their liquidity management practices to comply with the new regulatory requirements.

• The Advisor Outsourcing Rule proposal seeks to ensure that investment advisers maintain high standards of oversight and accountability when outsourcing critical functions. By requiring comprehensive due diligence, ongoing monitoring, and enhanced disclosures, the rule aims to protect investors and maintain the integrity of advisory services. The rule applies to registered investment advisers who outsource 'covered functions' that are critical to providing investment advisory services. Covered functions include portfolio management, risk management, compliance, and other core activities. The proposal extends to the use of index providers by advisers managing index-based products, including ETFs. While the SEC does not have direct jurisdiction over index providers, this rule would allow indirect oversight through the advisers who use their services.

Actively Managed ETFs

Rule 6011 has facilitated the growth of actively managed ETFs, now constituting 70% of the market. Active strategies are in demand, particularly in large-cap categories. However, certain strategies may not be suitable for ETFs due to fees, liquidity constraints, or inability to leverage the in-kind mechanism. Tax efficiency and demographic trends drive ETF growth in the U.S.

Last year, the flows into active ETFs were concentrated in four major categories: (i) Large Cap Blend; (ii) Equity Income; (iii) Large Value; (iv) Large Growth. These categories represented significant areas of interest and investment within the active ETF market, reflecting the demand for diversified, income-generating, and growth-oriented investment strategies.

The 2024 Fixed Income Landscape & Best Strategies

Current high yield levels create a favorable environment for fixed-income investments. Investors use index funds to make strategic decisions, with opportunities available in electronic trading and constructing index-like portfolios. Active management is crucial for capturing themes and maintaining portfolio quality without excessive risk.

Defined Outcome ETFs: Accelerating Growth and Innovation

Defined outcome ETFs offer pre-defined outcomes over specific periods, appealing to investors seeking equity exposure with predictable results, such as retirees. Innovations in this space include digital assets and crypto, with significant growth expected in evergreen buffer products.

ETF Trading in the New Era of T+1

The shift to T+1 settlement on May 28 will introduce operational and settlement challenges, including same-day affirmation requirements and potential for more failed trades. Total cost of ownership (TCO) and best execution practices will remain important considerations.

Around the Globe: Best Opportunities in ETFs for 2024

Promising sectors include the music industry, consumer discretion, metals and mining, oil and gas, renewable energy, and clean tech. Thematic growth, such as pop culture ETFs, and rising copper demand are notable trends. Equity derivatives ETFs are gaining popularity, with interest in inverse and income ETFs. The SEC's decision on Ethereum ETFs and existing levered financial products highlight ongoing regulatory and market developments.