Home ETFdb.com The SEC’s Thorn For Thematic ETFs

The SEC’s Thorn For Thematic ETFs

For weeks, the fund management world has pored over the more than 400 pages of rules proposed by the Securities and Exchange Commission that would make ETF issuers say more about their methods for picking securities according to ESG or factor principles.

However, one paragraph in the proposal could effectively ban one of the most popular methods issuers, and indexers use to select securities for emerging investment ideas.

Why The SEC Wants To Expand The 80% Rule 

The thrust of the 209-page rule proposal is an expansion of the so-called “80% rule”, where a fund that uses a specific descriptor in its name must have at least 80% of its holdings directly connected to that descriptor. Currently, this rule primarily affects funds named after a specific sector or geography. The SEC’s proposal would expand it to include strategies, factors, and other investing terms with less universally-defined meanings.

Also at issue is text analytics, or the use of artificial intelligence to scrape financial documents to count how often keywords are used in certain contexts by a company to describe their activities or customers.

Dozens of ETFs on the market use text analytics to select companies within an investment theme, particularly when issuers seek to construct exposure to an emerging theme that doesn’t have a large set of companies dedicated to the industry yet.

Regulators are wary of the practice, at least as a standalone method for assigning stocks to a theme, industry, or some other investment category.

“Although text analysis may be a helpful component of a fund’s analysis, we do not believe it is reasonable to conclude that an issuer is in a given industry solely because the issuer’s disclosure documents frequently include words associated with the industry,” regulators wrote in their proposal.

Content continues below advertisement

Quantifying The Qualitative For Thematic ETFs

Instead, the SEC suggests issuers and indexers use revenue- or asset-based tests to determine how linked a company’s fortunes are tied to a given theme. For example, several indexes underpinning thematic or industry-specific ETFs already require companies to produce at least half their revenues from a specific activity to qualify for inclusion.

Regulators also seem comfortable with including a company dominant in a specific market, even if that company’s involvement in the industry doesn’t account for the majority of its revenues.

“Sometimes you can [include] quality-play or marginal companies that are generating 20% or 10% of their revenue depending on the theme and the index,” said Rahul Sen Sharma, managing partner at Indxx. His firm does not use textual analysis for its thematic indices.

The potential clampdown could pose a headache to issuers and index providers who have used text analysis to try and quantify a company’s interest in a thematic idea, especially a theme like a metaverse that spans across sectors and doesn’t have many firms dedicated to it yet.

Market research firms like Grandview Research. have suggested that the promise of a fully immersive internet could become a $1 trillion industry by the decade’s end. But the biggest players in the metaverse space right now aren’t solely metaverse-focused.

Take Meta Platforms. Mark Zuckerberg has bet the future of his $500 billion social media giant on the metaverse, going so far as to rename the company and buy out the rights to the ticker ‘META’ from the Roundhill Ball Metaverse ETF (METV) that launched months before the rebrand.

Meta’s metaverse division, Reality Labs, which accounts for just 2.5% of the company’s $27.9 billion revenue, lost $2.96 billion in the first quarter of 2022.

Semiconductor and graphics card producer Nvidia is also a stalwart in the top 10 holdings of several metaverse ETFs, based on the theory that the metaverse needs real-time graphics rendering to operate. While the company is betting that its 3D graphics-related suite of products will bloom into a long-term source of revenue, it’s difficult to glean from the firm’s latest reports exactly how much of its revenues are coming from metaverse-specific sales.

Kip Meadows, CEO of fund administrator Nottingham, believes tightening the 80% rule would help keep investment advisors from including tangential stocks in their thematic strategies and may deter companies from using search engine optimization-like keyword strategies to heighten their chances of landing in an index.

He referred to a conversation he had with a fund manager in 2018 that pitched the idea of including Anheuser-Busch InBev in its cannabis portfolio, as the beverage giant at the time announced it would partner with Canadian firm Tilray to make cannabis-infused drinks.

“Well, wait a minute, is that really a cannabis-related security? No, it might be one day. What percentages will compete with Anheuser Busch’s revenues? Less than one-half of 1%,” he said. “Should it be in the fund? No.”

AB InBev and Tilray ended their partnership earlier this year.

What’s In A Name: Generic Vs. Specific

In theory, funds could instead become compliant by changing their names instead of their underlying strategies. Since the 80% rule is triggered when a fund manager uses a specific word to describe what might be inside its product, using generic words or phrases could reduce the risk of additional regulatory reviews.

“I think what will happen is you’re gonna have fund names that are not related at all to the underlying products, that are more generic, more neutral,” said Abby Bertumen, of counsel, focused on investment companies for Morgan, Lewis & Brockius. “…If text analytics is the only thing they’re relying upon, they’re just going to have to get more creative in terms of how they name their funds.”

That could make it more difficult for advisors and investors to understand at a glance what’s inside an investment portfolio, however.

Bertumen said it’s not entirely clear how the SEC intends to apply any of its proposals to the thousands of ETFs and mutual funds already trading on U.S. exchanges.

“Sometimes, for niche thematic products, that is both the best and only way to go,” said Gavin Filmore, head of product development at Tidal ETF Services.

Filmore doesn’t expect a ban on text analysis or an expansion of the name rule to totally cut off the stream of new thematic products, though, because being first-to-market with a generic fund moniker is often better than having a targeted name.

Take the Amplify Transformational Data Sharing ETF (BLOK) or the First Trust Indxx Innovative Transaction & Process ETF (LEGR), which both launched in January 2018 and now have $643 million and $134 million in assets under management, respectively. Those fund names evoke blockchain without using the word “blockchain,” whereas newer competitors like the $1.66 million Global X Blockchain ETF (BKCH) or the $5.3 million iShares Blockchain and Tech ETF (IBLC) have struggled to gain significant assets since launching in 2021.

Filmore, who aided BLOK’s launch, said regulators objected to the fund’s initial plan of using the term “blockchain” in its name.

“The basic advice would be if you get pushback on the name… you probably proceed anyway, and you’re just frustrated that you can’t use the name you wanted to use,” he said.

For more stories and commentary, visit VettaFi.com.

newETFs.io respects the hard work of others and gives all credit to the remarkable folks at ETFdb.com. This excerpt/article was pulled from their RSS feed; click here to view the original. Please note that on occasion, the RSS feed will not have the author. When this happens this site defaults the author to "News". Make no mistake, this excerpt/article was not created by newETFs.io, it was simply shared with you.