S Regulatory Ruling Is A Game Changer For ETF Industry

Lost in all the market volatility and concerns about interest rate hikes and inflation was a regulatory ruling that is destined to have a more lasting impact.  I expect it to distance iShares and Vanguard from the rest of the pack in terms of Assets Under Management. 

The New York State Department of Financial Services, the state's insurance regulator, in December published a new regulation that, until Jan. 1, 2027, allows shares of an ETF to be treated as bonds for the purpose of a domestic insurer's risk-based capital report provided the ETF meets certain criteria. The two most pertinent criteria that an ETF must meet to qualify under the new regulation are that the ETF tracks a bond index and has at least $1 billion in assets under management.  I predict this is going to be even more of a game changer for the ETF industry than the passage of “the ETF Rule” SEC Regulation 6(c) 11 in 2019.   

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The following two quotes come from a recent story by reporter Kathie O’Donnell in Pensions & Investments Magazine, a Crain corporation publication.

"This puts bond ETFs on a level playing field with bonds in an insurer's portfolio," Robert S, Kapito, President of BlackRock, said Jan. 14 during the company's earnings call for the fourth quarter 2021, adding that BlackRock is "very excited about the fact that insurers now will use more ETFs to represent their bond portfolio."  BlackRock is the sponsor of iShares.

The difference between treating a holding as debt rather than equity for risk-based capital requirement purposes "is orders of magnitude," attorney Daniel A. Rabinowitz, a partner at the law firm Kramer Levin Naftalis & Frankel... "You have to hold much, much more capital against equity securities."

Among criteria an ETF must meet to qualify under the new regulation are that the fund tracks a bond index and has at least $1 billion in assets under management.

There are 97 Bond ETFs that currently satisfy those two criteria.  The top 25 account for the lion’s share of the assets. Those ETFs have between $10 billion and $91billion in AUM. The remaining 72 have less than $10 billion apiece. Of these, there are another 20 Bond ETFs with between $5 and $10 billion. Two index providers, Bloomberg and ICE Data Services are dominant in AUM and number of products.

Taking a deeper dive, 17 of the largest 25 ETFs are iShares.  Six are Vanguard products with one apiece issued by Schwab and SPDRs.  It surprised me that four of the top 5 in AUM were Vanguard ETFs.  It also surprised me that very close to half (47.3%) of the total AUM in the top 10 were in those Vanguard products.  Here is a table from an ETF.com screen showing the top ten ETFs of the 97 that would qualify today under the new NY State Insurance rule reducing capital requirements.




Expense Ratio

AUM (Billions)



iShares Core U.S. Aggregate Bond ETF




Fixed Income: U.S. - Broad Market, Broad-based Investment Grade


Vanguard Total Bond Market ETF




Fixed Income: U.S. - Broad Market, Broad-based Investment Grade


Vanguard Intermediate-Term Corporate Bond ETF




Fixed Income: U.S. - Corporate, Broad-based Investment Grade Intermediate


Vanguard Short-Term Bond ETF




Fixed Income: U.S. - Broad Market, Broad-based Investment Grade Short-Term


Vanguard Short-Term Corporate Bond ETF




Fixed Income: U.S. - Corporate, Broad-based Investment Grade Short-Term


iShares TIPS Bond ETF




Fixed Income: U.S. - Government, Inflation-linked Investment Grade


iShares iBoxx USD Investment Grade Corporate Bond ETF




Fixed Income: U.S. - Corporate, Broad-based Investment Grade


iShares National Muni Bond ETF




Fixed Income: U.S. - Government, Local Authority/Municipal Investment Grade


iShares MBS ETF




Fixed Income: U.S. - Government, Mortgage-backed Investment Grade


iShares 1-5 Year Investment Grade Corporate Bond ETF




Fixed Income: U.S. - Corporate, Broad-based Investment Grade Short-Term

Summarizing some salient points from this table:

  1. The top 10 indexed bond ETFs account for $446.5 billion or about 37% of the $1.2 trillion currently in bond ETFs. 
  2. The two largest bond funds, one from iShares and the other from Vanguard, follow very similar total US bond market indexes and are almost identical in AUM, Together, they comprise about $170 billion.
  3. All of the Vanguard bond ETFs have iShares counterparts with only AGG being larger than the Vanguard entry.

In assessing what all this will mean for the exchanged-traded ecosystem requires two data points I do not have:

  • How quickly will insurance companies take advantage of the simplified operational processes, lower trading, custody, clearing, settlement and compliance costs and greater fungibility they would realize by replacing the bonds they hold with qualifying bond ETFs?
  • What is the dollar value of insurance company bond holdings that can potentially take advantage of this ruling?

From a bottom line and best practices perspective, the answer to the first question should be: ASAP.  However, in my 40 years in the investment industry, even the most obviously beneficial changes take at least months and generally years to be accepted and adopted.  It is also true that the US industry’s record of lightning-fast changes is less than prodigious. 

The answer to the second question requires knowing whether most of the other state insurance regulators will follow suit with similar rulings so that there is national adoption of this treatment of bond ETFs regarding capital requirements.  My expectation is that the national regulatory part of the equation will be taken care of very quickly.  Once that hurdle is overcome, I estimate that there are multiples of trillions of dollars of assets held by US insurance companies in the aggregate that could be converted in this manner into indexed bond ETFs.

Taken altogether the implications are huge.  As of yearend, according to ETFGI, a leading provider of institutional ETF Research, There were 2628 US equity ETFs comprising $5.5 Trillion in AUM.  In contrast, the number of bond ETFs was just 496 with assets of just $1.2 trillion.  In both cases the magnitude approaches five-to-one in favor of equities.  If this conversion of assets becomes a groundswell over the next 3 years as I suspect it must, the ratio of AUM should shrink from 5:1 to about 1:1 unless other factors intervene.  When you consider that the global context is that more than 70% of capital markets assets are in fixed income securities rather than equities, this global ETF AUM shift makes sense. 

Beyond insurance companies, what are the implications?

  1. Obviously, Blackrock and Vanguard will profit enormously.
  2. Schwab is perfectly positioned to add significant assets to its existing few products and create more that their customer could quickly help them meet the threshold criteria.  Looking at current customers also makes me think that FlexShares at Northern Trust could be able to take advantage of this move.
  3. SSgA’s SPDR brand is the wild card here.  Fixed income ETFs has simply not been a focal point for them until now.  To what extent are they in a position to change that quickly?  It will be interesting to see.
  4. Fee wars among all providers are likely in my opinion.  Most products are tightly priced in the single digits of basis points but TIPS, LQD and a few other iShares may have some wiggle room.
  5. For all investors, more assets mean more liquidity in Bond ETFs.  That is a very positive and could even become a self-feeding juggernaut. 
  6. Hedge Funds should find it easier to implement long-short strategies intrinsic to global macro and other arbitrage products.
  7. The three groups of products that this does not assist are active ETFs, preferred stock ETFs and equity ETFs.

It is generally not easy to predict a seismic change in the capital markets.  In this case, I must do so.  Be prepared to watch the US bond ETF market significantly outpace the growth of its equity counterpart during the next three years.

This commentary features my viewpoint and prediction of what will happen based on a recent regulatory ruling.  It is my conjecture, not yet validated by empirical ...

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