Exchange-traded funds (ETFs) are one of the most essential and profitable products developed in recent years for individual investors. ETFs have numerous advantages and, when used properly, can help an investor accomplish his or her investing objectives.
In a nutshell, an ETF is a collection of securities that you can purchase or sell on a stock exchange through a brokerage firm. ETFs are available in almost every asset class imaginable, from standard investments to so-called alternative assets such as commodities and currencies. Furthermore, novel ETF structures enable investors to short markets, obtain leverage, and avoid paying capital gains taxes on short-term gains.
After a few false beginnings, ETFs took off in earnest in 1993, with the product known by its ticker symbol, SPY, or “Spiders,” being the most popular ETF in history. ETFs are expected to be worth $5.83 trillion in 2021, with almost 2,354 ETF products trading on US stock exchanges.
Do ETFs qualify as securities?
An ETF is a collection of assets whose shares are traded on a stock market. They blend the characteristics and potential benefits of stocks, mutual funds, and bonds. ETF shares, like individual stocks, are traded throughout the day at varying prices based on supply and demand.
What are the different types of ETFs?
ETFs (exchange-traded funds) are SEC-registered investment businesses that allow investors to pool their money and invest in stocks, bonds, and other assets. In exchange, investors receive a portion of the fund’s earnings. The majority of ETFs are professionally managed by financial advisers who are SEC-registered. Some ETFs are passively managed funds that attempt to match the return of a specific market index (commonly referred to as index funds), while others are actively managed funds that purchase and sell securities in accordance with a declared investment strategy. ETFs aren’t the same as mutual funds. However, they combine the attributes of a mutual fund, which may only be purchased or redeemed at its NAV per share at the end of each trading day, with the flexibility to trade at market prices on a national securities exchange throughout the day. Before investing in an ETF, read the ETF’s summary prospectus and full prospectus, which contain complete information on the ETF’s investment objective, primary investment methods, risks, fees, and historical performance (if any).
Do ETFs qualify as NMS securities?
The Securities and Exchange Commission (SEC) proposed Rule 610T of Regulation NMS on March 14, 2018, to conduct a transaction fee pilot program (Pilot) with National Market System (NMS) equities. All of the major stock exchanges, as well as additional facilities and companies utilized by broker-dealers to complete trade orders for securities, including ETF shares, are included in the NMS, the national system for trading equities in the United States. Across three test groups, the Pilot will apply new temporary pricing limits to stock exchange transaction and alternative trading systems (ATS) fee pricing, including “maker-taker” fee-and-rebate pricing structures.
The exchanges and ATS will gather and publicly publish data on the impact of the three pilots, which will be evaluated by the SEC and industry participants in order to improve pricing, liquidity, and trade execution quality. Any regulation changes resulting from the Pilot will have a direct influence on ETFs on the most fundamental level: ETF share liquidity and execution quality, as well as the equity shares owned by the ETF. Prior to its introduction, ETF sponsors will have the opportunity to comment on the proposed Pilot.
The SEC’s adoption of Regulation NMS in 2005 aided the transformation of US equities markets from single trading systems to a large number of trading centers that comprise electronically linked stock exchanges and ATS. Orders, bid/ask quotations, available market players, and liquidity are scattered over the trading environment under NMS. NMS established regulations to protect orders and regulate intermarket trading, as well as rules to provide fair and efficient access to quotations and set costs for accessing protected quotations.
Since the passage of Regulation NMS, the SEC has conducted several evaluations of market structure and market events, reviewed and implemented new rules, and solicited feedback from the securities industry on how well and equitably NMS operates. The SEC has received input from the Equity Market Structure Advisory Committee (EMSAC) and other industry participants, including a recommendation for a pilot program that tests real-time theories on how changes to equity exchange transaction fees and rebates affect order routing behavior, execution quality, and overall market quality.
Exchanges and other trading centers collect orders from market participants to buy and sell ETFs and other securities and levy fees to its members and users when they match a purchase order against a sell request, resulting in an execution. As trading center rivalry heated up in the late 1990s, ATSs and subsequently exchanges began to provide rebates to entice order flow. According to the SEC’s announcement proposing the Pilot, the “maker-taker” fee model has emerged in the U.S. equities markets, in which a trading center charges a per-share fee at execution, pays a broker-dealer participant a per-share rebate to provide (i.e., “make”) liquidity in the securities, and assesses a fee to remove (i.e., “take”) liquidity. For example, a firm that facilitates a trade by posting buy and sell offers is compensated with a fee of approximately 20 to 30 cents per 100 shares transacted. A fee is imposed to companies that accept those shares. The difference between the charge paid by the taker of liquidity and the rebate paid to the provider or maker of liquidity is the trading center’s revenue.
Other pricing models exist, such as the “taker-maker” model (also known as an inverted model), in which a trading center taxes the liquidity provider and offers a rebate to the liquidity taker. The “access fees” that trading centers charge to access their quotes are governed by Regulation NMS Rule 610(c), which prohibits them from imposing, or permitting to be imposed, “any fee or fees for the execution of an order against a protected quotation… that exceed or accumulate to more than $0.003 per share.”
Several issues have been raised in recent years concerning the maker-taker fee model, including rebates offered to entice orders. Some have questioned whether the current fee structure has created a conflict of interest for broker-dealers, who must pursue the best execution of their customers’ orders while facing potentially conflicting economic incentives from the trading centers to which they direct those orders for execution to avoid fees or earn rebates—both of which are typically not passed through the broker-dealer to its customers.
The SEC proposed the following Pilot after obtaining information from a variety of sources, including the EMSAC. The Pilot consists of three test groups, as stated in the table below: one will restrict rebates and linked pricing, while the other two will set caps of $0.0015 and $0.0005 for removing or supplying displayed liquidity, respectively.
Are ETFs considered taxable securities?
Investment advisers and broker-dealers can use National Compliance Services, Inc.’s registration and compliance services. The question of whether a share of an exchange-traded fund (“ETF”) structured as a unit investment trust (“UIT”) is a “reportable security” within the meaning of Rule 204A-1(e) has arisen in advising our clients on compliance with Rule 204A-1 under the Investment Advisers Act of 1940 (the “Advisers Act”) (10). We respectfully request the staff’s assurance that, unless the ETF is a “reportable fund” within the meaning of Rule 204A-1(e), it will not recommend enforcement action to the Commission against our clients who are registered investment advisers if they do not treat ETF shares as reportable securities (9).
An ETF is a registered investment company organized as an open-end management investment company, a unit investment trust, or a similar entity that holds securities constituting or otherwise based on or representing an investment in an index. Its shares or other securities are principally traded on a national securities exchange or through the facilities of a national securities association and reported as a national market security.
1ETFs only sell and redeem their shares in huge blocks known as creation units at net asset value.
Individual ETF shares, on the other hand, can be bought and sold at market prices by investors throughout the trading day.
Because of the arbitrage opportunities inherent in the ETF structure, ETF shares have rarely traded at a large premium or discount to net asset value in the secondary market.
12
In January 2005, the combined assets of the country’s ETFs were $222.89 billion.
3
The bulk of exchange-traded funds (ETFs) are structured as open-end management investment companies (OMICs).
Some of the larger ETFs, on the other hand, are structured as UITs.
DIAMONDS Trust, Series 1, had net trust assets of $8.19 billion on October 31, 2004;4 MidCap SPDR Trust, Series 1, had net trust assets of $6.54 billion on September 30, 2004;5 Nasdaq-100 Trust, Series 1, had net trust assets of $20.38 billion on September 30, 2004;6 and SPDR Trust, Series 1, had net trust assets of $45.72 billion on September 30, 2004.
7
According to Rule 204A-1, every registered investment advisor must establish, maintain, and enforce a written code of ethics that requires access individuals to file reports of their holdings of, and transactions in, reportable securities, among other things.
Rule 204A-1(e)(10) defines a “reportable security” as a security as defined in Section 202(a)(18) of the Advisers Act, with certain stated exceptions, such as shares issued by open-end registered investment organizations that are not reportable funds (i.e., registered investment companies with which the registered investment adviser has certain relationships).
8
Except for the tiny number of investment advisers for whom the ETF is a reportable fund, the majority of ETFs are open-end registered investment companies, and their shares are not reportable securities under Rule 204A-1.
ETFs organized as UITs, on the other hand, do not qualify for any of the exclusions in Rule 204A-1(e)(10), and their shares are thus reportable securities in the strictest sense of the term.
9
The exceptions to the “reportable security” definition are designed to exclude stocks that appear to present minimal chance for the type of unlawful trading that the access person reports are designed to detect, according to the Commission’s Adopting Release.
10
We believe that ETFs, which are among the most transparent and liquid instruments available, are especially unlikely to provide possibilities for illegal trading.
Furthermore, there appears to be little need to distinguish between ETFs organized as unit investment trusts (UITs) and ETFs organized as open-end investment companies (OEICs).
Because of their generally larger size, better liquidity, and high level of transparency and liquidity of their underlying holdings, ETFs constituted as UITs are even less likely than other ETFs to present chances for inappropriate trading.
We believe that financial advisers regard ETF shares as a single type of security and that an arbitrary requirement to discriminate between ETFs organized as open-end investment companies and ETFs organized as unit investment trusts will confuse them.
It’s worth noting that the way ETFs are treated under Rule 204A-1 has generated some consternation in the industry.
This firm’s members have attended three conferences in the last few months where the topic has been discussed.
As a result, a no-action response would provide important guidance to the sector.
Are all ETFs RICS-compliant?
Yes, in a nutshell. Under the Investment Company Act of 1940, most ETFs (Exchange Traded Funds) are registered as investment firms with the Securities and Exchange Commission (SEC). As a result, they are classified as RICs (Registered Investment Companies) for legal and tax purposes, exactly like regular open-end mutual funds.
Almost all ETFs fall within this category.
Commodity-based ETFs and exchange-traded notes, on the other hand, are subject to distinct rules (or ETNs, which are sometimes confused with ETFs, but are very different in nature).
If you possess an ETF (not an ETN or a commodity-ETF, though), you can safely use the designation RIC for purposes of identifying dividends for foreign tax credit reasons when entering data into TurboTax (and for completing Form 1116, the foreign tax credit form).
Are ETFs preferable to stocks?
Consider the risk as well as the potential return when determining whether to invest in stocks or an ETF. When there is a broad dispersion of returns from the mean, stock-picking has an advantage over ETFs. And, with stock-picking, you can use your understanding of the industry or the stock to gain an advantage.
In two cases, ETFs have an edge over stocks. First, an ETF may be the best option when the return from equities in the sector has a tight dispersion around the mean. Second, if you can’t obtain an advantage through company knowledge, an ETF is the greatest option.
To grasp the core investment fundamentals, whether you’re picking equities or an ETF, you need to stay current on the sector or the stock. You don’t want all of your hard work to be undone as time goes on. While it’s critical to conduct research before selecting a stock or ETF, it’s equally critical to conduct research and select the broker that best matches your needs.
Are futures considered non-marketable securities?
“Any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options,” according to Rule 600(b)(46) (17 CFR 242.600(b)(46)).
The phrase “NMS Security” refers to exchange-listed equities securities and standardized options in general, but excludes exchange-listed debt securities, securities futures, and open-end mutual funds that are not currently reported under an effective transaction reporting plan.
The current effective transaction reporting plans and the effective national market system plan for reporting transactions in listed options that are significant for the purposes of Rule 13h-1 as of March 2012 are as follows:
Question 1.2: Does the identifying activity level apply to a person’s trading activity in a single security or across all securities?
A “large trader” is defined as someone who “directly or indirectly… exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any NMS security… by or through one or more registered broker-dealers, in an aggregate amount equal to or greater than the identifying activity level,” according to Rule 13h-1(a)(1)(i).
The term “identifying activity level” is defined in Rule 13h-1(a)(7) as “aggregate transactions in NMS securities” that are equal to or greater than the stated levels. Furthermore, a trader shall consider his or her total trading in all NMS securities effected through broker-dealers when computing his or her threshold activity level, as established in Rule 13h-1(c).
Transactions must not be netted inside or among accounts for computing the threshold trading level, according to Rule 13h-1. To put it another way, the identifying activity level refers to a person’s overall trading activity.
If more than one significant trader has investing discretion over a single account, each person only needs to count the specific transactions that they accomplished for the purposes of determining the identifying activity level threshold. Because LTID numbers are associated with accounts, all transactions in the account would still need to be tagged with all appropriate LTID numbers.
Question 1.3: How are the possibilities for determining the level of activity calculated?
According to Rule 13h-1(a)(7), the identifying activity level is defined as the total number of transactions in NMS securities equal to or more than:
- Two million shares or shares with a fair market value of $20 million on a calendar day; or
- Either twenty million shares or shares with a fair market value of $200 million throughout a calendar month.
Except for certain clearly listed transactions, the Rule defines “transaction” as “any transactions in NMS securities, excluding the acquisition or sale of such securities pursuant to option exercises or assignments.”
“The volume or fair market value of the equity securities underlying transactions in options on equity securities, purchased and sold, shall be aggregated,” says Rule 13h-1(c)(1)(i) for stock options. “The fair market value of transactions in options on a group or index of equity securities (or based on the value thereof), purchased and sold, shall be aggregated,” says Rule 13h-1(c)(1)(ii) for index options.
“For purposes of determining the identifying activity level with respect to options, only purchases and sells of the options themselves, not transactions in the underlying securities subsequent to exercises or assignments of such options, must be counted,” according to the Adopting Release (34-64976).
What happens if Form 13H isn’t filed?
Failure to file Form 13H when required (whether intentionally or unintentionally) can result in a variety of penalties under the Securities Exchange Act.
Are OTC stocks considered NMS?
The Securities Acts Amendments of 1975 established the National Market System, which is regulated by the National Association of Securities Dealers (NASD) and NASDAQ. The NMS regulates both exchange-based and over-the-counter (OTC) trading on the New York Stock Exchange and the NASDAQ. Even though the talks take place directly among market marks, the NASDAQ is treated as an exchange for practical purposes.
The NMS mandates exchanges to make bids and offers (ask price) open and transparent to both retail and institutional participants in order to support the fair dissemination of information. The benefits include more liquidity and lower prices. The system, on the other hand, makes it impossible for institutions and huge investors to carry out large deals without being discovered. Some claim that the increased visibility has spurred off-exchange trade, resulting in the growth of private exchanges known as dark pools.