Goldman Sachs and Pimco are leading a push for equal rights when it comes to running index funds tied to the global bond market.

Pimco and Goldman are joined by OppenheimerFunds and Nuveen Fund Advisors in asking the SEC for more flexibility in constructing ETFs that track indexes. Approval would put them on the same footing as three ETF pioneers — Vanguard, BlackRock’s iShares unit and State Street.

While stocks comprise almost 80% of ETF assets, bonds are the industry’s next frontier for growth, according to BlackRock Chief Executive Officer Larry Fink. Because bonds are harder to locate and trade than stocks, money managers are asking the SEC to relax constraints it imposed on index-based ETFs as they became the fastest-growing vehicle for investing in equities.

Risk-retention requirements have had a “chilling effect” on the market for mortgage bonds that lack a government guarantee, Pimco said.
Pimco is among the firms asking the SEC for more flexibility in constructing ETFs that track indexes. Bloomberg News

“The real impetus for this has come from the debt people,” said Kathleen Moriarty, an attorney at Chapman & Cutler who helped obtain approval in the early 1990s for the first ETF in the U.S., the SPDR S&P 500 ETF Trust. Managing an index ETF “becomes more difficult with bonds, especially if you are talking about anything other than Treasury bonds.”

BlackRock, Goldman and Oppenheimer, all based in New York, declined to comment, as did Newport Beach, California-based Pimco and Nuveen of Chicago.

SEC CHANGES
This could be the time to persuade the SEC to loosen its restrictions. Jay Clayton, appointed by President Donald Trump to head the SEC earlier this year, spent his legal career representing Wall Street firms — including Goldman — and is expected to cut back on regulations that he views as stifling job growth and capital formation. In September, Clayton appointed Dalia Blass, an ETF specialist at the law firm Ropes & Gray, to head the SEC’s division of investment management, which oversees the fund industry.

Edward Baer, an attorney in the San Francisco office of Ropes & Gray, is representing all four firms that filed the revised ETF applications. Baer didn’t return calls seeking comment.

ETFs in the U.S. hold about $3.2 trillion of assets, including roughly $2.5 trillion of equities and $566 billion of debt securities, according to data compiled by Bloomberg. The latter figure equals just 1% of global bonds outstanding, but Fink predicted in an Oct. 3 television interview with Bloomberg News that ETFs will become 15% of the fixed-income market in five years.

“We are a big believer that ETFs will play a bigger and bigger role in bonds,” Fink said. One reason is that managing individual bonds “is still incredibly cumbersome.”

EARLY ENTRANTS
State Street won approval to start the nation’s first ETF in the early 1990s, then iShares got the go-ahead in 1996, when it was still part of British bank Barclays. With the industry in its infancy, such early entrants obtained the SEC’s blessing to run ETFs in a more flexible manner than subsequent applicants.

Unlike mutual funds, ETFs trade throughout the day on stock exchanges. Each ETF obtains the securities for its portfolio by trading with stock and bond dealers that it has designated as a so-called authorized participant. In exchange for delivering baskets of securities to the fund, the participant receives shares of the ETF it can hold or sell on the open market.

When it comes to fixed-income ETFs, the early applicants can simply look at the inventory of bonds held by their authorized participants and pluck out the ones that best help them track the appropriate index. But ETFs established after 2012 can only accept baskets from dealers that precisely reflect their benchmark — a virtual impossibility for bond funds that track fixed-income indexes composed of hundreds of different securities — or they must take cash from the dealers and then go find the bonds they need.

“It has always been a mystery to me why the SEC clamped down on the ability to do custom baskets,” said Peter Shea, an ETF specialist at law firm K&L Gates. “People who got ETF exemptive relief before 2012 don’t have that straitjacket.”

Goldman and the others are requesting the same latitude accorded to those that obtained approval before 2012. Authorized participants for Goldman’s ETFs “may receive or deliver” a creation basket “that does not correspond pro rata to the identities of the portfolio holdings of the fund,” according to language the firm included in its application filed on Oct. 2. The others added similar wording.

Bloomberg News