ETF rule: Vanguard’s view

October 4, 2018


Vanguard has filed a comment letter expressing strong support for the U.S. Securities and Exchange Commission's proposed new rule intended to modernize and streamline ETF regulation. Vanguard also recommended enhancements to the rule that it believes can further protect and better inform ETF investors.

Since their introduction in the marketplace in 1993, ETFs have brought considerable value to investors by offering diversification, low costs, and potential tax benefits, all in a package with greater trading flexibility than traditional mutual funds. ETFs have grown substantially since then, with more than 2,000 U.S.-domiciled ETFs available today, representing $3.7 trillion in assets.

The proposed rule's aim is to establish a clear and consistent framework for the vast majority of ETFs operating today. Most ETFs that satisfy certain conditions would be able to operate under the proposed new rule and come to market without the cost and delay of the current regulatory process—referred to as obtaining an exemptive order from the SEC. The rule, if implemented, is intended to foster greater competition and innovation in the ETF marketplace by lowering the barriers to entry.

Highlights of the proposed rule

The SEC sought industry comment on its proposal. Among many features, the rule would:

  • Apply to all index and actively managed ETFs, except ETFs within a multiple-share-class fund (such as most of Vanguard's ETFs), leveraged and inverse ETFs, unit investment trust ETFs, and exchange-traded managed funds.
  • Impose certain conditions on the ETFs that would be subject to the rule, including disclosure of daily portfolio holdings.

Affected ETFs would have approximately one year after the final rule is adopted to implement necessary changes.

Vanguard's views on the proposal

Vanguard believes that permitting most ETFs to operate without obtaining an exemptive order is positive because it simplifies the regulatory process.

While Vanguard believes the proposed rule provides many benefits to investors, it offered additional modifications for the SEC to consider to further protect the best interest of ETF investors.

An alternative to full daily disclosure of portfolio holdings

Namely, Vanguard suggests that the SEC require disclosure of all portfolio holdings except the small portion that can be used by some market participants to harm ETF investors, such as securities that are subject to sensitive trading strategies during index changes.

Daily disclosure of an index ETF's full portfolio holdings can harm the ETF and its investors by negatively impacting the prices at which the ETF trades holdings and thereby reducing investors' returns. This arises from market participants' ability to use daily portfolio holdings disclosure to trade ahead of index funds.

The potential for trading ahead is particularly acute during index rebalances. Many index funds will attempt to preserve shareholder value when rebalancing as a result of an index change, which often means trading before or after the effective date to reduce transaction costs or associated market impact of the fund’s trading. Index fund managers will weigh the potential transaction cost savings against the risk of an increase in tracking error to determine an optimal trading strategy around an index change.

Full daily portfolio holdings disclosure gives other market participants full view of a fund’s need to buy or sell securities. Some of those market participants could use such disclosure and the index’s methodology to determine the precise amount of particular securities a fund must purchase or sell and trade ahead of the fund’s transaction. That can cause the fund to pay more, or receive less, for a security than it otherwise would and thereby hurt fund performance.

A focus on investors’ best interests

Vanguard is committed to promoting ETF regulation that is in the best interests of ETF investors. The SEC's goal of modernizing the rules governing ETFs represents a laudable step toward that end. Vanguard looks forward to working with the SEC and its industry peers to craft a rule that benefits ETF investors.

Read Vanguard's comment letter to the SEC on the SEC website.


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