Who regulates ETFs?


Regardless of product structure, all ETFs and mutual funds must comply with the disclosure-based provisions of the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act) and associated Securities and Exchange Commission (SEC) rules. These acts require all issuers of securities to disclose material information via prospectuses and annual reports to help investors make informed investment decisions.

Mutual funds and ETFs organized as investment companies must also satisfy the substantive regulations and disclosure requirements of the Investment Company Act of 1940 (1940 Act) and associated SEC rules. The 1940 Act imposes a host of investor protections—including restrictions on affiliated transactions, limitations on leverage, the independence of boards, and the segregated custody of fund assets—making mutual funds and ETFs subject to the 1940 Act among the most stringently regulated investment products available in the United States.

Keep in mind that ETFs structured as open-end investment companies and unit investment trusts (UITs) are regulated by the 1940 Act. Other ETF structures that mainly accommodate alternative investments restricted in a 1940 Act vehicle—grantor trusts, partnerships, and exchange-traded notes (ETNs)—are not regulated under the 1940 Act and may not provide its additional protections.

Why different ETF structures were developed | more

During the first decade of ETF development, all ETFs were created as 1940 Act vehicles. Like index mutual funds, these ETFs replicated index strategies in traditional asset classes such as stocks and bonds, which met the criteria for 1940 Act regulation. The first ETF was a unit investment trust, but the open-end form eventually became the predominant 1940 Act structure because it allowed for more investment flexibility.

As the ETF industry matured, ETF structures arose outside of the 1940 Act to accommodate the demand for ETFs in alternative asset classes and strategies, many of which cannot be easily executed in a 1940 Act vehicle.

For example, ETFs that invest solely in physical-based commodities and currencies are typically regulated as grantor trusts, not as 1940 Act vehicles, because investments in physical commodities and currencies are restricted in a 1940 Act vehicle. ETFs that invest in commodity or currency futures are regulated as commodity pools by the Commodity Futures Trading Commission (a government agency that regulates futures and option markets) under the Commodity Exchange Act of 1936 and taxed as partnerships.

Lastly, ETNs are prepaid forward contracts that represent unsecured debt obligations of the issuer to pay investors the return of an index (minus expenses). ETNs are typically issued for difficult-to-access markets.

It's important to remember that there are two key differences between mutual funds and ETFs. First, individual investors in ETFs cannot redeem their shares directly with the issuing fund (instead, only certain authorized participants can do so, in large blocks of ETF shares). Second, individual investors buy and sell ETF shares at prevailing market prices throughout the business day, whereas investors buy and redeem mutual fund shares at net asset value, determined at the close of the market each business day.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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