On November 8, 2018, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Exam Program Risk Alert announcing its 2019 examination initiatives focused on matters relevant to mutual funds and exchange-traded funds (“ETFs”).1 These initiatives illustrate OCIE’s continued commitment to examining matters important to retail investors, as mutual funds and ETFs are their primary investment vehicles. Here we focus on the ETF initiatives.
During examinations, OCIE staff will look at the activities of ETFs and their advisers, as well as the oversight exercised by ETFs’ boards of directors. OCIE’s 2019 examination areas described below mirror those of its 2018 initiatives for ETFs.
Smaller ETFs and/or ETFs with Little Secondary Market Trading Volume
Smaller ETFs and ETFs with little secondary market trading volume may (i) show increased bid/ask spreads and increased premiums/discounts to net asset value and (ii) face an increased risk of being delisted from an exchange. During examinations, OCIE staff will assess whether:
- investment risks are adequately disclosed to investors, including risks associated with liquidating an ETF;
- board of director oversight includes the ETF’s ability to continue as an ongoing concern;
- tracking errors are effectively monitored;
- portfolios are appropriately liquidated for distribution to shareholders upon liquidation, as applicable; and
- delisting and associated liquidation proceedings have received the requisite board approvals and oversight, as applicable.
Index ETFs that Track Custom-Built Indexes
Custom-built indexes are created and/or maintained for the exclusive use of a single ETF or ETF sponsor and used to
- evaluate the risks and challenges unique to ETFs with custom-built indexes and the adviser and index provider roles as they relate to index component selection and weighting, ongoing index administration, ETF management, and related performance advertising;
- review how the portfolio is managed compared to the ETF’s investment strategy disclosures;
- determine the services provided by the index providers and the adequacy of disclosures made to the ETF’s board of directors regarding these providers;
- assess whether conflicts of interest between the index providers and advisers are appropriately addressed; and
- review the effectiveness of the ETF’s compliance program for portfolio management and the board of director oversight.
ETFs Managed by Advisers Relatively New to Managing Such Products
Given that ETFs operate under the Investment Company Act of 1940 and certain prescribed exemptions thereto, advisers may lack experience or sufficient knowledge regarding the statute, its requirements, and exemptive order conditions. The resulting potential lack of adequate compliance support increases the risk of failing to comply with ETF-specific regulatory requirements, engaging in prohibited transactions, and/or omitting information that must be disclosed to investors. During examinations, OCIE staff will evaluate:
- ETF governance to ensure the board of directors has sufficient information to perform its duties,
- the effectiveness of the adviser’s and the ETF’s compliance programs, and
- marketing and distribution efforts related to the ETF.
With its risk alert, OCIE is giving ETFs and their advisers and boards of directors a head start on reviewing, and possibly strengthening, their compliance programs. These entities should review each examination focus area for relevance to their business. For each area that is relevant, ETFs and their advisers should (i) test the focus area; (ii) review risk and control matrices, policies, and procedures; (iii) enhance or begin personnel training in these areas; and (iv) review disclosures to shareholders and reporting to the board. They should also consider noting in detail in their annual compliance reports the steps they take to address these focus areas.
1 See “Risk-Based Examination Initiatives Focused on Registered Investment Companies,” November 8, 2018, available here. See also ACA Compliance Alert “OCIE Risk-Based Examination Initiatives Focused on Mutual Funds” available here.