Chuck Jaffe: It's time to update outdated mutual-fund rules
In most games and sports, equipment keeps evolving. Think clubs with a greater sweet spot in golf, oversized tennis racquets, aluminum baseball bats and more; each evolution of equipments gets weighed, measured and ultimately becomes part of the rule book, or tossed out.
In the mutual-fund game, the equipment is evolving too, but with rules that date back to 1940, there's a disconnect between old guidelines and modern developments.
That came to a head last week when a two-year quest by Huntington Asset Management to turn an existing mutual fund into an exchange-traded fund ended with the Securities and Exchange Commission standing squarely in the path of evolution.
It's a situation that illustrates why it's high time for regulators to stop applying Band-Aids and stopgaps to their problems and overhaul the Investment Company Act of 1940, which governs mutual funds. ETFs weren't even a thought in 1970 and no one behind the original legislation seven decades ago could have foreseen what the fund business has matured into.
The Huntington case shows why inconsistent application of the rules is a problem for fund investors.
In June 2010, Huntington filed to launch two actively managed ETFs: the Huntington Ecological Strategy Fund and the Huntington Rotating Strategy Fund, the latter being a clone of a traditional fund that, as of March 31, had more than $40 million in assets. Huntington's ultimate plan was to close the traditional mutual fund, folding it into the new ETF, allowing shareholders to move the money tax-free.
While traditional mutual funds still dominate the business and hold the most assets, it has become almost universally accepted in the industry that the ETF structure is better for shareholders. Exchange-traded funds offer easier, more-flexible trading, greater transparency and minor tax advantages over their traditional counterparts.
That said, both structures still fall into the broad category of "funds." In fact, Morningstar reorganized its fund-analysis structure, showing in the process that what matters most is the management and the asset class, rather than whether an issue is a traditional fund, exchange-traded fund or closed-end fund.
Where there used to be a separate team overseeing ETFs and funds — so that one analyst followed large-cap funds while another tracked large-cap ETFs — the new system is an acknowledgment that asset types and styles matter more than whether someone has an ETF or traditional fund.
In that light, Huntington's conversion plan was a no-brainer, an idea that other firms with the stones to live in the higher-transparency world of ETFs were looking to follow.
Instead, the Securities and Exchange Commission nixed it, without providing guidance on where the problems lie.
SEC approval would have made it much easier for any fund firm to make a conversion and, in fact, would have encouraged it.
There currently about 50 actively managed ETFs, a pittance compared to the number of actively managed traditional funds. The most notable of that small group is the ETF version of Bill Gross's PIMCO Total Return fund; that fund's fame allowed management to launch the ETF without assets, knowing the money would flow.
SEC isn't having it
By comparison, a firm like Huntington that starts an ETF from scratch is not likely to draw the big flood of money, especially because the denied conversion means it can't use the traditional fund's track record to market the cloned ETF. Allowing track-record carry over for cloned funds makes sense, but the SEC isn't having it, at least not in cases like Huntington's.
Functionally, every new ETF needs to get an "exemption" to the '40 Act because the law is so out of date that it doesn't recognize ETFs; without an exemption, a fund firm would be violating the law by running an ETF. SEC types would contest the point, but any objective observer sees that exemptions aren't always granted with an even hand.
Huntington launched the Ecological Strategy fund in mid-June, and expects to open the Sector Rotation ETF by the end of July. Most industry watchers expect the firm to eventually file paperwork that will allow it to fold the traditional fund into the ETF, resulting in the same planned ending, but without the track record and after a much longer, more costly process.
Ultimately, the antiquated way that ETFs get approved is holding back the evolutionary process. It's unclear who that benefits, but it's distinctly not in the best interest of consumers, who are being held hostage in the ETF revolution because of the antiquated rules..
"The exemption process was put into law to give the SEC the ability to operate under a law that was never designed to accommodate ETFs and the new products we see today," said industry consultant Geoff Bobroff of East Greenwich, R.I.
"There's no consistency, and no one [at the SEC] is spelling out what has to be done to get over the bar; they'll grant an exemption in one case and deny it in the next when the funds are similar. The process shouldn't be this hard ... it's time for a change, but it's not happening. Until it does, ETFs will [evolve] in starts and stops."
Chuck Jaffe is senior
columnist for MarketWatch.
He can be reached
or at P.O. Box 70,
Cohasset, MA 02025-0070.