The ETF Innovation Black Hole

Dave Nadig has forgotten more about market structure than I will ever know. He co-founded Cerulli Associates in the early 1990s, went on to be Managing Director at Wells Fargo Nikko before selling the firm to Barclays to form BGI, before THAT got bought to become Blackrock/iShares as it exists today. In the early 2000s Dave joined what would become, where he helped build their ETF Data and Analytics business which was sold to FactSet in 2017 or so.  Most recently Dave was part of the team that formed and sold VettaFi to the TMX group from 2020 to 2023. Dave is currently an “independent financial futurist” and will tell you what that means as soon as he figures it out! 

Dave writes an excellent substack called Echo Beach where you can read this note and many others. You can contact Dave at [email protected] and on Twitter at @DaveNadig. As with all of our guest contributors, Dave’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.


Welcome to regulatory stagnation: ETF Industry style.

Earlier this year I gave some predictions for 2024’s ETF stories, so let’s check in.

First, some context:

For most of my adult life, I’ve played in the ETF sandbox because it’s been the most interesting game in town: the maximally efficient encapsulation of market capitalism. Everything interesting in investing has run through the ETF infrastructure for the past 30 years.

Except, not so much anymore. For all the GenX whining about “late-stage capitalism” it is in fact true: we are at the Zeno’s paradox vanishing point for packaging risk in ever narrower and liquidity-defying containers, and the current regulatory (and let’s be really really clear, legislative) environment is such that nothing novel, innovative or even interesting is going to happen for at least a little while.

Let’s run through some of hot-button areas dominating the agendas of ETF conferences and YouTube conversations.

The Share Class Trap

If there’s one big hanging chad in ETF regulation right now, it’s the issue of Vanguard’s now expired share-class patent. Pretty much half the industry has now filed for some version of “let me make ETFs out of my Mutual Funds” or “Let me make a Mutual Funds out of my ETFs” share class approval. CBOE has the only timed filing out there, with a 19b4 that seeks to list ETF-share-classes. It’s a bit of an open issue about whether this would even be required, although should they get approved, they’ll have a faster-track towards getting some new ETF share classes trading (through new generic listing standards).

The important bit, however, is that 19b4s are one of the *only* SEC filings where the deadlines and dates actually mean anything. The SEC actually has to respond to CBOE by December 11th (if I have my math right). Theoretically, if they *don’t* the rule becomes effective, although a pocket veto seems extremely unlikely.

Between now and then, my survey of lawyers and insiders show mixed opinion, but the smartest and most connected folks I know believe absolutely nothing happens until the CBOE filing is dealt with, and even then, I’m left with extreme skepticism the SEC allows anything novel or innovative to happen on their watch without another APA lawsuit.

I’m not suggesting they have any good reason to deny the filings: “You let Vanguard do it” is a very good argument. But lets remember the whole reason the SEC is concerned about a blanket approval — they’re worried about conflicts of interest and cross-class subsidization. They’re worried that (say) a fund having a bunch of different share classes with different fee structures creates the potential that one class might benefit the firm more than others, or might lead to investor confusion and differential incentives that put one class of investor ahead of another in some way. And yes, they’re worried that having one share class (the ETF share class) wash out capital gains for the whole pool of assets (as it has with Vanguard) through heartbeat trades while other share classes “free ride” on the ETF creation/redemption process creates disparate treatment.

These are completely reasonable concerns. I’m not saying they are accurate concerns — I think it’s hard to show the harm to ETF shareholders, for instance, if they engage in “excessive” heartbeat trades designed just to run decades worth of embedded gains through the scrubber. But they are not irrational concerns.

It’s not clear that the IRS could just change the playing field – the tax treatment of in-kind transfers is hardly a new thing, and plenty of tax attorneys have been recommending changes (and ensuring their unemployment in finance) for years. Every so often a big paper title like this one gets things stirred up

But then something shiny happens and we forget about it entirely. You know what will make the IRS *not* forget about it? Suing the SEC over how unfair it is that your ETF company can’t play Vanguard’s game. It likely takes more than just a smart IRS employee. It probable takes congress. But that’s not off the table at all.

Senator Wyden failed in his hamhanded attempt to remove:

“Section 311(b) shall not apply to any distribution by a regulated investment company to which this part applies, if such distribution is in redemption of its stock upon the demand of the shareholder.” 

from the code in 2021 but I wouldn’t bet on that lasting forever.

Given a choice between keeping the code intact, or opening up the share class floodgate, I know which door I’d pick.

Square-Peg 401ks

I was pretty negative on ETFs and 401k plans and I still am, but that won’t keep the industry from trying. While I may think there’s just no reason nor enough demand to crack the 401k market open to ETFs (CITs are a better fit in every regard, IMHO), I could absolutely be wrong. The most interesting way would be for Anna Paglia (New head of SSGA, and I’m a big fan), to make good on her promise to Bloomberg a few weeks ago.

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