OCIE Eyes ETF Custom Indexes, Small and Thinly Traded ETFs, and Liquidation Process

ETF Update

Date: November 26, 2018

Key Notes:

  • The SEC’s examinations office is focusing exams on ETFs with “custom indexes” and those that are small or have low trading volume, and it has issued a Risk Alert highlighting its concerns in these areas.
  • This Alert follows recent comments from SEC officials on custom indexing from earlier this year.
  • ETFs that have custom indexes, have low AUM or are thinly traded should review their disclosures, compliance policies and procedures, and board communications in light of OCIE’s concerns outlined in the Alert.

In the midst of apparent continuing sweep examinations of ETFs that focus on the use of “custom-built indexes” (Custom Indexes), thinly traded ETFs, and the process of closing and liquidating ETFs, the SEC’s Office of Compliance Inspections and Examinations (OCIE) publicized its examination approach to these issues when it issued another in its series of Risk Alerts[1] on November 8, 2018. Discussed below are aspects of the Alert that are particularly relevant for certain ETFs. OCIE stated in the Alert that it will assess through examinations the policies and procedures in place at ETF complexes addressing the risks and conflicts raised by the use of Custom Indexes, smaller ETFs and those with low trading volume, and the ETF liquidation process, including board oversight of such risks and conflicts. It will also examine the ETFs’ disclosures to investors and boards about such risks and conflicts.

Custom Indexes and Their Providers

The Alert is the SEC’s latest public statement on ETFs’ use of Custom Indexes, which was foreshadowed by prior public pronouncements. The issue was first raised at the ICI Mutual Funds and Investment Management Conference in San Antonio on March 19, 2018 when Dalia Blass, the director of the SEC’s Division of Investment Management, discussed her concerns regarding ETFs and funds using Custom Indexes. She focused on an adviser or sponsor of a fund who uses a custom-built or bespoke index that is an index created and/or maintained by an index provider for a single fund or its sponsor. In that speech, Director Blass also spoke about registered advisers who themselves created indexes for their funds (ETFs using this approach are referred to as self-indexed ETFs), as well as whether non-registered sponsors of Custom Indexes should in fact be registered with the SEC as investment advisers.

In June 2018, the SEC proposed Rule 6c-11 under the Investment Company Act of 1940 (1940 Act), which would permit most ETFs that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order. That proposal did not impose additional requirements for self-indexed ETFs (although the SEC requested comment on whether it should do so) or address the use of Custom Indexes.[2]

Based on statements in the recent Alert, OCIE presumably has requested or will request from ETF complexes information about and documents related to self-indexing and the use of Custom Indexes. The Alert notes that when examining ETFs engaged in self-indexing and/or using Custom Indexes, OCIE will focus on:

  • Risks associated with the roles of the adviser and Custom Index provider related to the selection and weighting of Custom Index components; ongoing index administration; management of the fund; and related performance advertising.
  • Whether the fund is being managed in a way that is consistent with its disclosures.
  • The services rendered by a Custom Index provider for the fund.
  • What was disclosed to the fund’s board on its role.
  • Whether any conflicts of interest between the Custom Index provider and the adviser are appropriately addressed.
  • The effectiveness of the ETF’s portfolio management policies and procedures and related board oversight.
Small and Thinly Traded ETFs

In the Alert, OCIE highlighted the risks to investors from ETFs that are subscale or have limited secondary market trading volume. Risks noted were wide bid/ask spreads, large premiums or discounts to net asset value (NAV), potential delisting, and related liquidation costs. In its exams on this point, OCIE will assess the following:

  • Risk disclosures relating to ETFs with limited secondary market trading.
  • Board oversight of the ETF’s ability to continue as an ongoing concern, and the delisting and liquidation process.
  • For passive ETFs, monitoring of tracking error.
  • The process for liquidating the ETF’s portfolio and providing liquidation proceeds to shareholders.
ETF Liquidations

A somewhat new area of focus for OCIE, at least in the context of small and thinly traded ETFs, is on the liquidation of ETFs. Because of stock exchange listing requirements and the costs associated with operating an ETF, ETFs close and liquidate at a far higher rate than their mutual fund cousins. This relatively higher rate of liquidations may have prompted OCIE to examine this process more closely and see the need to raise ETF liquidation as an issue in the Alert. It is advisable to consider OCIE’s concerns even for ETFs that are not small or thinly traded if there are other reasons for pursuing liquidations.

In the Alert, OCIE states that in its exams it will assess ETF liquidations in the context of small and thinly traded ETFs by focusing on whether:

  • ETF portfolios are appropriately liquidated for distribution to shareholders upon liquidation.
  • Delisting and associated liquidation proceedings receive the requisite board approvals and oversight.
Other Areas of Focus

OCIE also raised several other areas of concern that are not ETF-specific, but rather apply to ETFs and mutual funds alike:

  • Aberrational underperformance of a fund relative to peer groups.
  • Funds holding a relatively higher percentage of securitized assets such as mortgage-backed securities.
  • Conflicts associated with side-by-side management of registered funds and private funds.
  • Funds managed by advisers who are relatively new to the registered fund business.

ETFs with Custom Indexes:

  • ETFs should review whether their disclosures are consistent with how the ETFs and Custom Indexes are being managed, and ensure that conflicts of interest between index providers and advisers are appropriately and prominently discussed.
  • ETFs should also review their policies and procedures on compliance with exemptive order conditions (in the case of self-indexed ETFs), portfolio holdings disclosure, and how conflicts of interests between advisers and index providers (or adviser personnel and index provider personnel, if housed within the same entity) are addressed.
  • Communications with the board regarding the roles of the index provider and adviser for a Custom Index should include information on the services provided by the index provider and compensation arrangements.

Smaller ETFs and ETFs with limited secondary market trading:

  • ETFs should review the content and frequency of disclosures to their boards regarding trading volume, bid/ask spreads and premiums/discounts to NAV.
  • ETFs should review policies, procedures and practices with respect to compliance with continuing exchange listing standards.
  • ETFs should review their risk disclosures to ascertain whether the risks of delisting, and the burden of associated liquidation costs, are appropriately addressed.

ETF liquidation process:

  • ETFs should make sure adequate policies and procedures are in place governing the liquidation process, which include coordination with relevant service providers.
  • ETFs should review their risk disclosures to ascertain whether the risks of delisting, and the burden of associated liquidation costs, are appropriately addressed.
  • ETFs should maintain records related to the liquidation process, including the plan of liquidation and documents demonstrating how the liquidation process was carried out.

For more information, please contact:

Bibb Strench

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[1] OCIE National Exam Program Risk Alert: Risk Based Examination Initiatives Focused on Registered Investment Companies (Nov. 8, 2018), available at https://www.sec.gov/files/OCIE Risk Alert - RIC Initiatives_0.pdf.

[2] See Exchange Traded Funds, Investment Company Act Rel. No. 10515 (June 28, 2018) (Proposing Release).