Barclays Global Investors is blazing the trail for the exchange-traded fund (ETF) business as federal regulators have lifted key investment restrictions on its iShares product.
The Securities and Exchange Commission earlier this month issued an exemptive relief order permitting mutual funds to invest in iShares exchange-traded funds in excess of the maximum amount outlined in section 12(d) of the Investment Company Act of 1940. The move is a significant milestone for the San Francisco-based asset manager as it makes iShares the first ETF family to be exempt from an investing limit.
Section 12(d) prohibits an investment company from acquiring more than 3% of the total outstanding voting shares of another investment company. Secondly, it restricts investment companies from investing more than 5% of their total assets in a single investment company. The section also prohibits investing more than 10% of total assets in two or more investment companies.
Richard Morris, senior counsel at Barclay's, told Money Management Executive that the firm decided to seek an exemption to the '40 Act after hearing complaints from its mutual fund clients that they were bumping up against section 12(d) limitations. This created obstacles for them when it came to executing their investment strategies. For example, if an investment company were to launch a new niche product such as an international fund, it could easily find itself hitting the 3% limit on who could hold what. The problem there is that it is too costly to market such a product when prospective clients can only hold such a small percentage.
Tactical Allocation
Even more significant is the ability for other funds to hold more than 5% of total assets in any one ETF. For example, if firm XYZ is a mutual fund with residual cash and it is already invested in a growth fund but seeks exposure to technology, a smart play would be to put that cash into the Nasdaq 100 Unit Trust (QQQ). However, the fund could find itself having to reshuffle its holdings in order to avoid holding more than the restrictions allowed. Essentially, it impedes a fund manager's tactical allocation and investment style.
"The relief will allow our mutual fund clients and mutual funds who previously were restricted in the amount they could invest in iShares greater flexibility to achieve their asset allocation and investment strategies," said James Parsons, managing director of Barclays' intermediary business, in a prepared statement.
ETFs are a unique investment tool in that they are by definition a fund, but at the same time they behave like a stock. Like stocks, market makers match buy and sell orders to keep them liquid. Each ETF tracks a particular stock index ranging from the benchmark S&P 500 to specific industries, countries and investment styles. Typically, mutual funds use ETFs to gain immediate exposure to equities. This is possible because they can enter into a position at any point during a trading day. Most mutual funds, on the other hand, can only trade at the market's close.
Portfolio managers also use them to employ short strategies or gain liquid exposure to a broad range of markets and sectors. And since ETFs do not use flows to buy and sell securities directly, capital gains taxes are minimized for investors. iShares, for one, are index funds that trade on the American Stock Exchange, the Chicago Board Options Exchange and the New York Stock Exchange in the same way as shares of a publicly held company. An investor can purchase and sell iShares through a brokerage account, advisor or sub-advisor and can trade them anytime during normal trading hours.
Still, iShares are not shares of a company but rather shares of a portfolio designed to closely track the performance of any one of a variety of market indices. Like many of their index fund counterparts, iShares are designed to have relatively low portfolio turnover, which reduces transaction costs incurred by the fund and minimizes capital gains distributions to investors.
Some industry sources have speculated that the exemptive order could potentially boost the firm's market share in the ETF space. At present, Barclays has about a 30% market share in the U.S.
Given that it is the only firm with the exemption and it offers the most funds in that category, that appears to be a sound argument.
BONY Next in Line
Joseph Keenan, vice president and global ETF product manager at Bank of New York, applauded the move for exemption saying it was "a good thing" not only for Barclays, but also for all firms that offer ETFs. Bank of New York, which offers the Standard and Poor's Depository Receipt (SPDR), the oldest and largest ETF in terms of total assets, is in the process of submitting a similar request, one that he expects the SEC to look upon favorably.
"If you have a restriction and somebody else doesn't, you certainly want to fix that," Keenan said. "I can't imagine that you would speak to anybody that has an ETF product out there that isn't looking at this, if not ready to lick the stamp and send [a request] to the SEC."
Still, Keenan doesn't anticipate a significant shift in market share because mutual funds tend not to use these instruments for long-term investing. In fact, he explained that during semi-annual and annual reporting periods, it's difficult for a portfolio manager to justify why he or she is holding somebody else's fund. The only plausible reason for holding ETFs for the long term, he said, is if the firm planned to develop a fund-of-ETFs.
Morris conceded that while it should certainly be a contributing factor to the growth of Barclays' business over the long haul, he doesn't expect to see an immediate impact in terms of asset growth.
"I don't believe through this relief alone you'll see any erosion of the SPDR market share," Keenan said. "It's not going to be the match that lights the firecracker."
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