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Chuck Jaffe

The little ETF that couldn't

7/1/12 9:01 AM ET (MarketWatch)

BOSTON (MarketWatch) -- Most games evolve as innovative technology is implemented in the equipment, such as baseball bats, golf clubs, tennis racquets at the like.

In the mutual fund game, the equipment is evolving too, but rules that date back to 1940 create a disconnect between the old and the new.

The break was fully exposed 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.

The situation shows why it's time for regulators to stop applying Band-Aids and stop-gaps to their problems and overhaul the Investment Company Act of 1940, which governs mutual funds.

All in the family

ETFs weren't even a thought in 1970 -- the last time the '40 Act went through a significant rewrite -- and no one behind the original legislation seven decades ago could have foreseen what the fund business has become.

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 and fold it into the new ETF, allowing shareholders to move the money tax-free.

While traditional mutual funds 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, just this week, investment researcher Morningstar Inc. 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 -- Morningstar's new system is a tacit acknowledgement 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 really providing any guidance as to 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.

Stop the revolution

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 (BOND) of Bill Gross's Pimco Total Return Fund (PTTAX) , whose fame allowed management to launch the ETF without assets, knowing the money would flow.

By comparison, a firm like Huntington that starts an ETF from scratch is not likely to draw the big 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 carryover 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. 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 (HECO) 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.

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 archaic 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," he added. "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."