Monday, July 2, 2018

Big Changes for ETF Basket Files

Monday, July, 2, 2018 - The tenor of the global trade debate continued to weigh heavily on the markets, as stocks swung between loses and gains in tandem with this week's bouts of escalation and moderation of trade tensions. Against this precarious backdrop, the DJIA and S&P 500 shed 1.3% apiece and the tech-heavy NASDAQ dropped 2.3% for the week. Within the S&P 500, energy stocks outperformed after oil prices rose to a four year high on a larger than expected drawdown in U.S. crude inventories and news that the U.S. intends to levy sanctions on countries that don't eliminate all oil imports from Iran by November 4th. Health care and Consumer Staples lagged, fueled by fears over the disruptive potential of Amazon's acquisition of online pharmacy PillPack. Mixed economic signals also figured prominently in this week's market action. Inflation rose to a six-year high, reaching the Fed's target 2% rate in May. A downward revision of first quarter GDP from 2.2% to 2.0% and a 0.6% drop in durable goods orders in May were among the other notable economic headlines.

The ETF industry experienced a watershed moment this week as the SEC voted 5-0 to modernize the regulatory framework for this fast-growing space. To date, ETFs have relied on individual exemptions from the nearly eighty-year-old Investment Company Act of 1940 for approval of new products. This ad hoc process has created significant time and costs for product launches and lent an advantage for established ETF providers.

Proposed Rule 6c-11, which will undergo a 60-day comment period, will standardize the approval process, allow issuers to launch ETFs without receiving exemptive relief from the SEC, and rescind all previously granted exemptive relief orders. The proposed rule will apply to all ETFs structured as open-ended funds, while multi-share class funds (like Vanguard funds) UITS, non-transparent ETPs, and leveraged and inverse and other esoteric ETPs will still receive additional SEC scrutiny. All issuers will also be required to publish certain information about their funds every day, such as premiums/discounts and bid/ask spreads.

Another significant element of the proposed rule is the standardization of custom creation/redemption baskets for all ETF issuers. Years of bespoke exceptions gave rise to portfolio management flexibility for some ETF providers at the expense of others. Prior to 2012, the SEC gave ETF issuers the latitude to use a custom sample of their fund's holdings to facilitate the creation/redemption process. This exemption was ended in 2012 and now all ETF issuers operating without this exemption must conduct of full replication of their individual holdings during a creation/redemption. Not only has this given incumbent providers a decided advantage when managing their portfolios, it has also spawned a pervasive, but seldom understood disparity between the constituents of the basket and holdings files of ETFs.

As many ETFs often have thousands of constituents or track less liquid asset classes, geographic regions, or strategies, a full holdings replication during the C/R process is often too unwieldy and cost inefficient. Thus, to reduce transaction costs and minimize tracking error, pre-2012 ETF issuers will publish a portfolio composition file (PCF), also known as a basket file, which represents a sample of an ETFs holdings that they will accept for a creation. The basket file will aim to match an ETFs risk/reward profile and frequently represents only a sample of an ETF's full holdings. This practice is ubiquitous as you move beyond the extremely liquid broad-based Large Cap equity ETFs.

Basket files are used to facilitate the C/R process and holdings files represent a full look through of an ETF's constituents and are used for any aggregate fund calculation, such as end of day NAV. With the new ruling, the disparity between basket and holdings files will widen even further and, consequently, there will be a corresponding increase in the importance of recognizing the distinction between these two files.

The SEC first proposed an ETF-specific rule a decade ago, but their rule making deliberations were derailed by the onset of the financial crisis. This week's proposed rule is a momentous development, adding fresh momentum to the $3.6 trillion dollar industry and further cementing its place in the investing mainstream.

Our weekly Quant Movers lists is heavily populated by funds caught up in ongoing global trade tensions. The funds suffering the largest declines in their quant scores this week were largely all trade sensitive funds - SCHA, ACWF, VOE, ECNS, IPAC, FLIO, MOM, OASI, RFDA, and FTXR. However, our model also does identify some value picks for funds that have been battered by the rise of trade conflicts and emerging market currency fluctuations - QAT, FEUZ, FLM, VYMI, EWT, AMZA, PID, EIDO, VOT, and EMCG.

In the holiday-shortened week ahead, trading volume will likely be light, but investors will still continue to negotiate the latest developments in global trade tensions.

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