New complex EFTs may face long wait for OK by SEC

PHOENIX Wed Dec 7, 2011 1:50pm EST

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PHOENIX Dec 7 (Reuters) - Sponsors of U.S. exchange-traded funds should not expect regulatory approval for more complex, and higher-fee, products anytime soon, attorneys specializing in funds said.

The Securities and Exchange Commission, already slowed by numerous rule-making proceedings from the Dodd-Frank Act, is backing away from allowing more innovation in ETFs as complaints about the funds' impact on markets mount, according to Michael Mundt, a partner at Stradley Ronon Stevens & Young.

When the SEC disclosed a wide-ranging probe of the ETF market at a congressional hearing in October, Mundt, a former SEC assistant director, said he was surprised at the "laundry list of things" the agency planned to study.

"There almost seems to be a bit of a back to basics mentality," Mundt said, speaking on Tuesday at the "Super Bowl of Indexing" conference here.

That is bad news for ETF sponsors like BlackRock and Vanguard Group, which have asked the SEC for permission to create more complex funds that would not disclose all of their holdings on a daily basis.

The fund sponsors have acknowledged that it could take years for the SEC to approve their filings.

"I'm pessimistic about what the future holds in terms of expansion of the market for innovative products," Stuart Strauss, a partner at Dechert LLP, said at the conference.

Strauss said there is a growing perception among lawyers outside the SEC that the agency "is being extraordinarily cautious in expanding the ETF market into new products."

The SEC in March 2010 suspended approval of new leveraged or actively managed ETFs that rely on derivatives and has not acted on filings seeking to delay or abandon daily disclosure of holdings. Most of the proposed funds use more complicated investment strategies, like those followed by hedge funds, than do more typical index-tracking ETFs.

Some of the proposed funds are also likely to carry higher fees than typical ETFs and provide new areas for growth in the market, which has been inundated with copy-cats of plain vanilla index offerings.

U.S. regulators are moving slowly because of complaints that some ETFs may be increasing market volatility or creating new, unforeseen risks for investors. ETF sponsors have argued the funds are being unfairly blamed for tough market conditions.

The go-slow approach should not affect applications by ETF sponsors to run funds based on in-house indexes, Strauss said. Almost all ETFs track indexes provided by third parties like MSCI , the Standard & Poor's unit of McGraw Hill and Russell Investments.

But BlackRock, the largest ETF sponsor, filed in August for permission to run funds based on internally created indexes. "It's already permitted right now for other firms," Strauss noted.

Representatives of the major indexing firms expressed little fear that fund firms would eat into their lucrative ETF licensing revenue.

"This is something we've seen for the last five, 10, 15 years," David Blitzer, chairman of the index committee at S&P, said at the conference. "It's just another form of competition and competition is good for everyone."

New index providers may find the field more difficult to break into than they expect, he added.

"They also may miss some of the checks and balances and other things we bring to it," Blitzer said. "We hope and expect to continue to be a major player."

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