Tuesday, March 20, 2018

IM Director Blass gives updates on board outreach, ETF, and index fund issues

By Lene Powell, J.D.

Division of Investment Management staff is “firing on all cylinders” on many projects including engaging with boards of directors and developing new valuation guidance, working to get an ETF rule on the books, and refining the division’s market surveillance tool (“MAGIC”) to add machine learning capabilities, IM Director Dalia Blass said in remarks to the ICI 2018 Mutual Funds and Investment Management Conference. The Division is also looking at index fund issues, including whether some custom index providers may be straying from the publisher’s exclusion from the need to register as an investment adviser.

Board outreach. Blass reported that in its “Board Outreach Initiative,” a Division team has been meeting with fund boards, independent directors, counsel to funds and independent directors, and independent auditors to understand board responsibilities and ask if the SEC can do anything to help fund boards serve shareholders. Staff is in the early stages of developing a recommendation for updating valuation guidance to reflect evolution in the markets and the standards for accounting, auditing, and reporting, said Blass.

ETFs. Delivering a rule recommendation for exchange-traded funds to the Commission is a “high priority” for the Division and staff is “hard at work” on this, said Blass. With no rule currently on the books, the $3.5 trillion ETF market operates under more than 300 individual exemptive orders. While this provides flexibility, it also creates costs, barriers to entry, and regulatory uncertainty. According to Blass, the situation is “not ideal.”

Another ETF issue is nomenclature. The term ETF used to mean something specific, but now is commonly used to describe investment companies with a wide range of strategies and some products that are not investment companies or even funds, said Blass. This blurring of the term can conceal important differences in risk. The Division is interested in hearing from investors, funds, and advisers on whether addressing this would be helpful.

Index funds. A similar blurring of terms has been happening around “index,” said Blass. At the beginning, indexes were broad and easily understood, like the S&P 500. Now, with bespoke and narrowly focused indexes, some index providers have moved away from a mere publishing role to something that may implicate registration as an investment adviser.

Blass encouraged index providers to re-analyze whether the publisher’s exclusion still applies, including considering the following:
  • What if the provider maintains an index for only one single fund? 
  • What if the provider takes significant input from the fund’s sponsor or board regarding the creation, composition or rebalancing of that index? 
  • Should affiliation between the index provider and the sponsor affect the conclusion? 
There may also be disclosure issues, said Blass. Providers should ask themselves if an investor can readily discern how decisions for the fund will be made, especially if the fund uses a bespoke index.

MAGIC market analytics. Blass discussed the Division’s market surveillance tool, Monitoring and Analytics GUI for Investment Companies (MAGIC). The tool combines different data sets to give views into performance, flow, holdings and other information. Staff can run custom queries across thousands of funds, allowing staff to ask questions like how a fund’s portfolio compares to its strategy, and whether its holdings are aligned with its investment restrictions. For example, staff can quickly identify which funds may have exposure to certain assets, like cryptocurrencies.

Staff plans to use MAGIC to implement a risk-based approach to reviewing disclosures. Staff is also working to expand the tool’s capabilities using additional data sets and machine-learning capability, allowing it to automatically detect fact patterns of interest. While “data will not make us clairvoyant,” it can improve the use of limited resources and contribute to better policymaking, Blass noted.