Should you launch an Active or Index ETF? This post dives into some of the regulatory & legal nuances involved.
If you are a consumer of ETFs or an intermediary that uses ETFs in client portfolios, understanding the differences between the index and active ETF regulatory regimes is extremely important because it will provide context for decision-making.
Also, as a disclaimer upfront, we are not lawyers. We are educators. This post is based on our best understanding of how the regulatory systems work via our experience launching numerous ETFs and our experience of being in the wealth/asset management business for over a decade. We will try to use simple language to facilitate communication and understanding. If you really want to get into the technical details you would need to hire an expensive 40-Act attorney who actually knows what they are talking about.
This piece is part of our continuing education series on ETF operations and logistics. You can find a recap and collection of the series here:
Let’s dive into some of the details of active and passive ETFs.
BOOORING…I already know the difference between Active and Passive
Are you sure?
Unfortunately, the definition of active and passive differ depending on your audience. Finance folks think about this differently than lawyer folks. For a deep dive into the differences, click here.
Below is a quick summary of the differences in understanding:
1) Finance geek understanding
For anybody who has ever studied finance, the definitions for active and passive are well-established (a shortened version of Bill Sharpe’s definition from the Arithmetic of Active Management is below):
Passive = Value-weighted index of all assets in a given market (e.g., the US stock market, often proxied by the S&P 500, or even more accurately proxied via the Wilshire 5000).
Active = Not passive.
On one extreme, an active portfolio might hold a single position in stock ABC. On the other extreme, an active fund might hold 490 out of ~500 stocks from the S&P 500. Both portfolios are active to varying degrees 4, but one thing is clear: they aren’t passive.
First, some background: ETF sponsors, until recently, had to file an exemptive application to the SEC. Why? In order to operate an ETF, a fund sponsor needs to do things that are not allowed based on the Investment Company Act of 1940, so they seek relief from these regulations from the SEC.
There are two primary types of relief:
Index relief — granted to those fund sponsors that systematically follow a process or index.
Active relief — granted to those fund sponsors that can choose to follow an index and/or invest based on their discretion.
Throughout the rest of this piece, we will focus on the lawyer’s understanding of active and passive, not the financial definitions. Sorry finance geeks!
I’m launching an Active ETF. What are my regulatory obligations?
Pretty simple: you need to be an SEC-registered Investment Advisor to manage an Active ETF. This applies even if you manage less than $100mm in assets.
What is an Active ETF?
An Active ETF is an ETF structure that offers the portfolio manager a lot of flexibility to achieve their investment objective and the “secret sauce” of their process does not need to be revealed to the world. Active ETF examples could be 100% discretionary stock pickers or 100% automated algorithms. The key difference between Active ETFs and Index ETFs is that these ETFs can change/adapt on the fly and are not beholden to the hard and fast rules of an Index ETF.
That said, Active ETFs still need to follow the process disclosed in their Prospectus. This is why you will see very vague “Principal Investment Strategy” descriptions in an actively managed ETF prospectus. In fact, the active manager is effectively in a tug of war with regulators (or more likely, their own attorneys). The SEC will want ample detail to inform a retail investor as to what the fund actually does, while the fund manager will want to keep the details as high-level as possible to avoid tipping their hand or disclosing their process. An active manager also wants maximum flexibility, and thus, more general verbiage.
What strategies work well in an Active ETF?
If you have a strategy that can benefit from flexible rebalance rules and/or elements of manager discretion, an Active ETF is the way to go. Also, if a manager is concerned about the intellectual property tied to their investment process, an active ETF will afford the manager an extra layer of IP protection (although one still needs to reveal their holdings every day!)
More importantly, the marketplace is slowly becoming more educated as to the nuance between active and passive. Active funds can follow very disciplined processes, akin to an index fund. Conversely, index funds can be very technical and complex, and appear to be almost active in nature.
What are the regulatory requirements to set up an Active ETF?
The most cost-efficient and expeditionary route for Active ETF sponsors is to get set up with a white label platform as an SEC-registered sub-adviser or co-adviser. The process checklist is as follows:
Set up an entity (e.g., an LLC)
Register the entity as an Investment Advisor (IA) with the SEC (SEC registration is required as an advisor to a 40-Act product).
Set up an individual as the Registered Investment Advisor (RIA) under your IA.
Build out and maintain a compliance program to manage conflicts of interest, marketing, and portfolio management oversight.
Launch an ETF.
Send trading signals to the ETF portfolio management team for execution (this can either be done via an in-house trading and execution team or an outsourced third party).
We do this on a frequent basis and the costs and brain damage are not torturous. For a simple highly focused compliance program, you are looking at 5-10k in start-up costs and probably 5-10k in ongoing costs for ongoing compliance program management. (cost estimates can vary wildly depending on complexity!). The key drivers of cost here are inversely correlated to the amount you are willing to do yourself. Learn more of the compliance gymnastics, costs are lower…outsource everything, and costs go higher.
As a sub-adviser or co-adviser, the assets in the ETF will be included on your ADV and you will be subject to the joy that is the Registered Investment Company Act of 1940 (you know, the year your grandfather was 17 and before he joined the Navy to fight the Japanese…that 1940).
I hate regulation. Can I launch an Index ETF to avoid it?
For many, the word “Compliance” evokes scenes of torture, overnight visits with in-laws, or both. Any “shortcut” that could avoid compliance altogether is a welcome event. Enter the Index Fund. Index Providers are exempt from federal oversight thanks to the “Publishers Exclusion.” Great! Let’s just launch an index fund, claim an exemption, and watch the compliance-free money roll in.
Not quite. Yes, by being an index provider, one can avoid SEC registration. However, compliance is still required, and many index providers learn all too late that key actions they want to take are forbidden (e.g., hiring salespeople). In short, there are costs/benefits to consider. First, let’s walk through the background on Index ETFs.
What is an Index ETF?
An Index ETF, unlike an Active ETF, seeks to track an underlying index. And the Index MUST BE 100% mechanical. So all rebalances, all algorithms — everything — must be spelled out ahead of time. There cannot be a discretionary aspect to the process and making changes to the Index cannot be made on a frequent basis. Moreover, the details of the process need to be disclosed.
What strategies work well in an Index ETF and what are the regulatory requirements?
Any strategy that is 100% systematic and trades in large liquid markets works great in an Index. Also, Index Providers themselves can show their index results (this is known as a backtest in ETF land) as “publishers”. Of course, one can NOT blend a backtest with live performance or show a backtest to retail investors.
For many index providers, this is a huge benefit over registering and running an active ETF; however, the SEC will look very carefully to ensure a North Korean style DMZ separates any mention of a security (backtests = bad) from an index site (backtests = bad, but SEC can’t regulate you). Of course, to the extent that consumers have learned that “nobody has ever seen a bad backtest,” the benefits of this marketing ability might be limited. In short, many like the index route, but be prepared to fully divorce oneself from the underlying fund and its marketing.
Sounds messy. What is driving the regulation of index providers?
The SEC wants to regulate index providers. This fight went all the way to the Supreme Court in Lowe vs. SEC back in 1985. The SEC lost, and bona fide Index Providers get to claim the publisher’s exemption and avoid Uncle Sam’s watchful eye. Nevertheless, the SEC still reserves the right to prosecute index providers that market securities. Furthermore, index providers that sponsor a fund can fall under even closer scrutiny.
We are all aware of obvious examples of an Index provider essentially marketing securities, without technically marketing securities. The best example is when Dave Portnoy promoted the BUZZ Index but this is OBVIOUSLY marketing BUZZ ETF.
Regulators aren’t stupid and attempts to “skirt” the intent of the rules will attract a lot of attention. One should expect that relying on the “newsletter exemption” to avoid SEC regulation will stay in place (backed by Supreme Court ruling). However, one should expect that regulators will attack index providers who directly or indirectly are deemed to be “marketing” a security through the facts and circumstances of the situation.
Because of the additional regulatory scrutiny and the inability to market securities as an Index provider, we actually recommend that any ETF sponsor desiring to launch an Index ETF ALSO register with the SEC. That way they serve as a ‘regulated’ index provider. So they can benefit from the transparency of an Index ETF, but they have the flexibility to market securities. Yes, you need to be regulated by the SEC, but that isn’t necessarily a bad thing!
Launching active vs passive ETFs – cost and benefit comparison
Active ETFs can be good because of the following:
The ability to market/sell securities
Potentially lower costs because an index calculation agent is not required
Less intellectual property flight
Index ETFs might be good because of the following:
Avoid regulatory burdens
Ability to show backtested performance under certain guidelines
Launching an active or index ETF: information is key
In summary, there are no right answers when it comes to launching an active or an index ETF. However, by understanding the basics of the regulatory landscape and the costs/benefits of each approach, both consumers and ETF operators can make more informed decisions. Thanks for reading!