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E xchange-Traded Fund (ETF) assets have grown dramatically in recent years. From $112 billion in 2019 to $509 billion in 2023, ETFs have logged a 35% five-year compound annual growth rate. For the past ten years, ETFs have grown consistently and gained significant market share relative to mutual funds. Since 2013, ETF assets have increased from 13% to 31% of total net assets relative to mutual funds, while mutual funds have slipped from 87% to 69%.

The rise of the Exchange-Traded Fund (ETF) structure has been significantly facilitated by favorable regulatory adjustments over the years. These adjustments have focused on improving transparency, reducing operational complexities, and increasing market access, which collectively have made ETFs an attractive investment vehicle. Here are some key regulatory developments that have contributed to the growth of ETFs:

1. SEC’s ETF Rule (Rule 6c-11)

Simplification and Standardization:

  • In 2019, the U.S. Securities and Exchange Commission (SEC) adopted Rule 6c-11 under the Investment Company Act of 1940, also known as the “ETF Rule.” This rule streamlined and standardized the regulatory framework for most ETFs, eliminating the need for individual exemptive relief applications, which were previously required for ETFs to operate. This change significantly reduced the time and cost associated with launching new ETFs.

Creation and Redemption Process:

  • The ETF Rule also clarified the operational procedures for the creation and redemption of ETF shares, which are central to the liquidity and pricing efficiency of ETFs. By standardizing these processes, the rule improved market participants’ confidence in the consistency and reliability of ETF operations.

2. Improved Disclosure and Transparency Requirements

Daily Portfolio Transparency:

  • ETFs are required to disclose their portfolio holdings on a daily basis. This transparency helps investors understand what they are buying and selling, which contributes to more accurate pricing and better-informed investment decisions. The SEC has mandated these disclosures to ensure that market participants can effectively assess the value of ETF shares.

3. Introduction of Non-Transparent ETFs

Active ETFs:

  • In recent years, the SEC has approved the launch of non-transparent or semi-transparent ETFs, which allow active managers to withhold daily disclosure of their full portfolio holdings. These products are designed to protect the proprietary trading strategies of active managers while still providing sufficient information to facilitate effective trading. This innovation has broadened the range of ETF products available, attracting more active managers to the ETF space.

4. Tax Efficiency

In-Kind Redemptions:

  • ETFs can utilize in-kind creation and redemption mechanisms, where securities are exchanged directly for ETF shares without triggering capital gains. This process helps ETFs minimize the tax impact on investors, making them more tax-efficient compared to mutual funds, which must sell securities to meet redemptions, potentially generating taxable events.

5. Global Regulatory Harmonization

Cross-Border Listings and Operations:

  • Harmonization of ETF regulations across different jurisdictions has facilitated the global expansion of ETFs. Regulatory bodies in key markets, such as the European Union and Asia, have adopted frameworks that align closely with U.S. standards, making it easier for ETF issuers to operate internationally and for investors to access a wider range of products.

6. Market Structure Improvements

Exchanges and Trading Infrastructure:

  • Regulatory support for improvements in market infrastructure, including the development of electronic trading platforms and enhanced market maker regulations, has increased the liquidity and efficiency of ETF trading. These advancements have made it easier for investors to trade ETFs at tight bid-ask spreads, reducing transaction costs and improving overall market accessibility.

Reaping the Benefits

Favorable regulatory adjustments have played a crucial role in the rise of ETFs by simplifying the regulatory framework, enhancing transparency, improving tax efficiency and fostering global harmonization. These changes have not only lowered barriers to entry for new ETF issuers but also increased investor confidence in ETFs as a reliable and cost-effective investment vehicle. As a result, ETFs have become one of the fastest-growing segments of the investment fund industry, offering a broad array of options to meet diverse investor needs.