Yesterday, the SEC proposed rules that would radically change how mutual funds and ETFs not only talk about their portfolios, but how they actually construct them.
The rules are complex—I read all 415 pages—but like any SEC rulemaking, it’s a process where we don’t know the outcome. Fundamentally, the SEC tends to get what it wants, so even after the comment period, I imagine some version of these rules will in fact become the law of the land.
The Big Idea
The core idea behind the proposed rules is to ensure that ETFs and traditional mutual funds (I’m just going to say “funds” from here on out) can meet redemptions if there’s a panic and, for whatever reason, investors want their money back.
To ensure this, funds would have to report an estimate of how long it would take to liquidate their entire position for every security held and would be limited to having no more than 15 percent of the fund in securities that would take longer than seven days to liquidate. Fund boards would also be required to analyze their patterns of redemptions and the funds’ portfolios to maintain a minimum percent of assets that could be dumped within three days.
The second part of the proposal is irrelevant to ETFs—it suggests a “swing price” net asset value that would allow mutual funds to pass through the cost of dumping securities to big redeemers by giving them, essentially, a worse price than a small redeemer.
Five Consequences in the Details
1. Portfolio disclosure for everyone!
One of the major reasons investors love ETFs is that they get to see what they hold. This is critical for institutions and sophisticated investors trying to maintain a full view of their entire portfolios, regardless of what combination of securities and ETFs they might have. Mutual funds, with their “once a quarter, 30 days delayed” disclosures make that view harder.
The new rule wouldn’t explicitly change this; however, funds would have to report directly to the SEC on a monthly basis. The commission goes out of its way to say that it would only release this data once a quarter, but I believe that’s a ruse—there will be significant pressure from institutional investors to make these monthly reports available, and once one investor has access, funds will be required to send it to everyone. The “easy” route will simply be full disclosure. That’s good for investors.
2. Big funds lose. Small funds win.
The key provisions of the rule are about unloading the entire position a fund holds. That means small funds will be disproportionately better off than large ones. The math here is really simple: Right now, the iShares Emerging Markets ETF has a 4.1 million share position in the National Bank of Abu Dhabi, making up about 0.05 percent of its portfolio.
Using FactSet’s Portfolio Analysis, I can calculate that would take roughly eight days to unload. For a fund that was half EEM’s size, it would take four days. So for EEM, the bank is an “illiquid asset,” but for an upstart, it’s not. This increases the likelihood that funds will have to either close for new money (leading to premiums) or pollute their portfolios with off-index-weight positions.
3. Trade impact analysis just became MIT's new major.
My eight-day calculation above is completely wrong—it's a sledgehammer version of how long it would take to unload, because it's just dividing the average volume by the total position. But what the rules actually say is that funds would need to estimate how long it would take to unload without having any market impact whatsoever.
That's obviously impossible. So what funds will have to do—or more likely, portfolio analytics and trading partners—is come up with good, justifiable models for how hard it is to really unload these positions. In reality, it might take iShares a month to unload the Bank of Abu Dhabi in its entirety with no market impact. Page 404 of the document makes some modest suggestions of the kind of things that will need to be taken into account:
(A) Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;
(B) Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);
(C) Volatility of trading prices for the asset;
(D) Bid-ask spreads for the asset;
(E) Whether the asset has a relatively standardized and simple structure;
(F) For fixed income securities, maturity and date of issue;
(G) Restrictions on trading of the asset and limitations on transfer of the asset;
(H) The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding. Analysis of position size should consider the extent to which the timing of disposing of the position could create any market value impact; and
(I) Relationship of the asset to another portfolio
Just a few land mines in there, eh? Having a good model here is going to be the difference between being able to actually run your fund and taking your marbles and going home.
4. Goodbye junk bonds?
My initial analysis of EEM—using the incredibly bad method of just average volume—suggests it’s sitting on about 8% of assets that would take longer than seven days to unload. As I said above, the real number is probably off by more than half.
But how about junk bonds? Or bank loans? The whole premise of these ETFs has been that they provide liquid access to illiquid assets. iShares published an excellent paper a few years ago pointing out that in the corporate bond space, ETFs now hold more in bond assets under management than the entire corporate dealer market held in inventory.
And even if we’re dealing with trace eligible bonds (the only real way to assess any fixed-income liquidity), the numbers don’t look good. In iShares’ enormous iBoxx $ High Yield Corporate Bond ETF, the largest position is a 6% Numerica Group bond, at about 0.5 percent of the portfolio, or $65 million notional. By my calculations, on a good day, that issue trades about $7 million, meaning the single most liquid bond in the portfolio will easily fail the seven-day liquidation rule.
Do I think junk bond funds will be banned? No. I think the SEC will back off and make exceptions for certain single-asset-class ETFs focused on liquidity-challenged sections of the investing landscape. But if I’m wrong, it’s goodnight Irene.
5. Illiquid asset classes will run for new structures.
Assuming everything proposed became law tomorrow, there are several ways around the problem. The first is to use swaps. Issuers like ProShares technically run traditional ’40 Act Mutual funds that hold two assets: cash and swaps. They get away with having one large derivatives position because, from an IRS perspective, the real asset is the giant pile of cash collateral being held against the swaps. That’s how you get 2X leveraged this and 3X minus that.
The same structure, however, could easily be used to launch, say, a clone fund tracking the same index as the iShares iBoxx $ High Yield Corporate Bond. It would be substantially less efficient than the current structure, but where there’s demand, product will blossom.
The other alternative is exchange-traded notes. While we’ve seen a huge slowdown in ETF issuance as banks have been unwilling to deal with the offsetting balance sheet entries on their living wills, that could change if there’s enough market demand.
The game is far from over on these new rules, but there’s little question that they’d have far reaching implications as written for ETF investors and the ETF industry. Expect a long round of comments where the ETF industry (rightfully) points out how disruptive this would be and suggests that the in-kind creation/redemption mechanism has a lovely way of handling liquidity crunches.
Whether the SEC listens or not is anyone’s guess.