ETF Providers Face Three Major Compliance Issues: Report

ETF Trends

While most exchange traded funds are structured like mutual funds, ETFs are not mutual funds, and providers will have to make that distinction in facing compliance issues.

“The leading compliance challenge confronting exchange-traded fund (ETF) sponsors is the threat of complacency,” Rajib Chanda, partner at Ropes & Gray law firm, wrote for Ignites. “It would be easy to presume that ETFs face compliance concerns identical to those of typical mutual funds — or worse, to presume that fewer concerns exist because ETFs typically employ passive investment strategies. Both presumptions are dangerously misleading.”

Chanda offers some basic points to consider when up against compliance issues: How are a sponsor’s ETF product and mutual fund product different? Do the same personnel service both mutual funds and ETFs? Are “non-traditional” ETFs or other exchange traded products and notes offered?

If a providers seeks to apply existing mutual fund compliance policies to new ETFs, some conditions need to be met to receive SEC exemptive relief. For instance, under Section 12(d)(1) of the Investment Act of 1940, unaffiliated funds that invest in ETFs can not go beyond the “3/5/10″ limits – a mutual fund can not own over 3% of outstanding securities of any one fund, cannot invest more than 5% of its assets in any single fund and cannot hold over 10% of its assets in investment companies.

Not surprisingly, providers cannot grant special treatment to authorized participants, who create and redeem shares of an ETF.

Regarding personnel on both ETF and mutual funds, compliance challenges occur when a sponsor tries to promote both ETF and traditional mutual fund simultaneously on a side-by-side basis. Specifically, ETFs cannot be marketed as “mutual funds.”

With the proliferation of new ETF strategies and styles, sponsors can not adhere to the same cookie cutter compliance issues for all ETFs as they have moved beyond the passive indexing structure. For instance, active ETFs will follow a different set of compliance. Additionally, ETFs that are associated with index providers or are based on in-house indices require so-called firewalls between the index side and the ETF side – changes to an index must be made public before being shared with ETF managers or others.

For more information on the ETF industry, visit our current affairs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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