Story available here: https://www.etftrends.com/the-secs-potential-thorn-for-thematic-etfs/
For weeks, the fund management world has pored over the more than 400 pages of rules proposed by the Securities and Exchange Commission that would make ETF issuers say more about their methods for picking securities according to ESG or factor principles.
However, one paragraph in the proposal could effectively ban one of the most popular methods issuers, and indexers use to select securities for emerging investment ideas.
For weeks, the fund management world has pored over the more than 400 pages of rules proposed by the Securities and Exchange Commission that would make ETF issuers say more about their methods for picking securities according to ESG or factor principles.
However, one paragraph in the proposal could effectively ban one of the most popular methods issuers, and indexers use to select securities for emerging investment ideas.
The thrust of the 209-page rule proposal is an expansion of the so-called “80% rule”, where a fund that uses a specific descriptor in its name must have at least 80% of its holdings directly connected to that descriptor. Currently, this rule primarily affects funds named after a specific sector or geography. The SEC’s proposal would expand it to include strategies, factors, and other investing terms with less universally-defined meanings.
Also at issue is text analytics, or the use of artificial intelligence to scrape financial documents to count how often keywords are used in certain contexts by a company to describe their activities or customers.
Dozens of ETFs on the market use text analytics to select companies within an investment theme, particularly when issuers seek to construct exposure to an emerging theme that doesn’t have a large set of companies dedicated to the industry yet.
Regulators are wary of the practice, at least as a standalone method for assigning stocks to a theme, industry, or some other investment category.
“Although text analysis may be a helpful component of a fund’s analysis, we do not believe it is reasonable to conclude that an issuer is in a given industry solely because the issuer’s disclosure documents frequently include words associated with the industry,” regulators wrote in their proposal.
Instead, the SEC suggests issuers and indexers use revenue- or asset-based tests to determine how linked a company’s fortunes are tied to a given theme. For example, several indexes underpinning thematic or industry-specific ETFs already require companies to produce at least half their revenues from a specific activity to qualify for inclusion.
Regulators also seem comfortable with including a company dominant in a specific market, even if that company’s involvement in the industry doesn’t account for the majority of its revenues.
“Sometimes you can [include]quality-play or marginal companies that are generating 20% or 10% of their revenue depending on the theme and the index,” said Rahul Sen Sharma, managing partner at Indxx. His firm does not use textual analysis for its thematic indices.
The potential clampdown could pose a headache to issuers and index providers who have used text analysis to try and quantify a company’s interest in a thematic idea, especially a theme like a metaverse that spans across sectors and doesn’t have many firms dedicated to it yet.
Market research firms like [Grandview Research](https://www.grandviewresearch.com/industry-analysis/metaverse-market-report#:~:text=b.-,The global Metaverse market size was estimated at USD 38.85,USD 47.48 billion in 2022.) have suggested that the promise of a fully immersive internet could become a $1 trillion industry by the decade’s end. But the biggest players in the metaverse space right now aren’t solely metaverse-focused.
Take Meta Platforms. Mark Zuckerberg has bet the future of his $500 billion social media giant on the metaverse, going so far as to rename the company and buy out the rights to the ticker ‘META’ from the Roundhill Ball Metaverse ETF (METV) that launched months before the rebrand.
Meta’s metaverse division, Reality Labs, which accounts for just 2.5% of the company’s $27.9 billion revenue, lost $2.96 billion in the first quarter of 2022.
Semiconductor and graphics card producer Nvidia is also a stalwart in the top 10 holdings of several metaverse ETFs, based on the theory that the metaverse needs real-time graphics rendering to operate. While the company is betting that its 3D graphics-related suite of products will bloom into a long-term source of revenue, it’s difficult to glean from the firm’s latest reports exactly how much of its revenues are coming from metaverse-specific sales.