By Jessica Toonkel and Ashley Lau
NEW YORK (Reuters) - The U.S. Securities and Exchange Commission may strip Vanguard Group, BlackRock Inc and State Street Corp, the oldest and biggest providers of exchange-traded funds, of an advantage they hold over newer rivals in how they assemble the shares of their funds, said sources familiar with the SEC.
ETFs are typically funds whose holdings are meant to mimic the performance of an index. To do that, the SEC has said the securities used to create shares in most funds must be the same ones as in the fund’s portfolio unless there was a change in the index the fund tracks.
But BlackRock, Vanguard and a few others, who were among the first to apply with the SEC to create ETFs, are allowed greater leeway: if they need a difficult-to-find security to create shares of their funds, they are permitted to use a similar security – not necessarily the same one – in the fund. This greater flexibility makes it easier and cheaper to run the older funds, and harder for newer entrants into the market such as Northern Trust, Van Eck Global and Charles Schwab Corp to compete.
The agency's tentative plan - still in its early stages - would affect how companies manage their portfolios in illiquid markets, such as bonds. It may result in allowing the likes of Schwab to compete better with their older rivals, as well as manage their existing bond products at a lower cost.
"Regulation should not create an uneven playing field that disadvantages certain shareholders," said Marie Chandoha, president and CEO of Charles Schwab Investment Management. "We believe strongly that steps should be taken to ensure that ETF investors benefit equally."
On Monday, officials from the SEC's Division of Investment Management told ETF executives that they thought they could address the issue without having to go through a formal rule change, typically a years-long process, according to six people familiar with the discussions who asked not to be named because they're not permitted to speak with the media.
The mechanism by which the SEC could provide that relief is complex. By not aiming directly at funds, but at the so-called trading baskets that ETFs are required to use to create and redeem shares, the SEC could probably effect changes with no-action letters or having ETF providers apply to amend their exemptive orders with the SEC to offer ETFs.
The officials, Dalia Blass, assistant chief counsel at the SEC's Investment Management division, Barry Pershkow, senior special counsel at the division and David Bartels, an attorney in the division, also indicated that nothing would likely happen until the SEC finds a replacement for Norm Champ, the former director of the investment management division who stepped down in January, sources said.
The SEC and ICI declined to comment.
ETFs, which trade on exchanges like stocks but hold portfolios of securities like traditional mutual funds, must create and redeem shares as investors buy and sell them. They do this through the basket mechanism.
When investors want to buy shares, a middleman, known as an authorized participant and typically a bank or broker, goes to the market and buys the securities, which are bundled into "baskets" and delivered to the ETF provider, who uses the newly purchased securities to create shares for investors. Conversely, when investors redeem shares, the authorized participant sells the securities in the open market.
While portfolio managers add and remove securities from their portfolios, the baskets can be a back-door way that other securities can get into a portfolio.
However, if many investors want to buy shares and there are not enough securities to create shares, the ETF provider may have to accept cash until they can find suitable securities.
And if many investors want to sell shares, but there isn't enough demand in the market to take those securities off the authorized participant's books, the authorized participant will charge the ETF provider for that additional risk.
Changing the requirements could cut costs for investors in some funds significantly.
For example, in April 2013, when investors put in orders to pull 21 percent of Vanguard Long-Term Corporate Bond ETF, it would have cost the fund at least 0.4 percent extra if it were restricted to the securities in its underlying index, according to a January 2014 presentation by Vanguard published on the SEC's site.
The change could have the unintended consequence of making ETF firms susceptible to being bullied by their trading partners, which has been a concern of the SEC, sources said. The worry is that authorized participants could force ETF providers to take certain securities they don't want off their books and into the fund portfolios. That could cause the funds to underperform.
"They could take on securities that they might not want as a favor and that's when things get hairy," said Dave Nadig, chief investment officer at ETF.com.
THE BOND FUND SQUEEZE
The issue has come to a head now because of the growing popularity of bond ETFs, which almost tripled in assets to $305.5 billion over the past five years, according to Morningstar.
Meanwhile, bond liquidity has all but dried up for corporate issues after post-financial crisis regulations forced Wall Street banks to slash their fixed-income inventories. That puts index-following bond fund managers in a squeeze, as they are required to keep their funds as exact mirrors of their indexes and are required to create or eliminate shares as money flows in and out."The industry has been complaining bitterly for a decade about the haves-and-have-nots," said Nadig at ETF. com. "This is the SEC taking a small step to address this complaint."
(Reporting by Jessica Toonkel and Ashley Lau in New York. Additional reporting by Sarah Lynch in Washington. Editing by Linda Stern and John Pickering.)