Since first entering the market in 1993, exchange-traded fund providers have had to ask government regulators for special exemptions to list on U.S. stock and bond exchanges.

The process can take years to complete and cost ETF firms millions of dollars to fill out the proper forms. Fund sponsors say it's tedious and doesn't really get to the heart of the most important issues facing ETF investors. 

Consumer advocates counter that any relaxing of such regulations could open the floodgates for poorly constructed and risky funds.

The debate is about to move to center stage. At the Securities and Exchange Commission's open meeting on March 4, a proposal was made to change two key rules. 

A two-month public comment period is now underway. After that, the SEC could officially adopt the rules, which many say would represent the most significant regulatory changes since ETFs were introduced 15 years ago.

But industry observers are warning that a host of issues, including those that are more procedural in nature to broader concerns about the impact on market pricing, could delay implementation of any reforms for quite some time.

Now, even those most optimistic about prospects for change say they doubt the SEC's proposals will pass public inspection intact. That's even though supporters say critics are missing an important fundamental issue central to the reforms.

Transparency Is Key

"The SEC's goal is not to decide on whether a particular ETF is a good investment or a bad one. In the U.S., that role traditionally falls to the market," said Stacy Fuller, an attorney specializing in investment company regulatory issues at K & L Gates, a Washington, D.C.-based law firm.

"The SEC's role has always been to make sure that ETFs are put on the market in a transparent manner," she added.

The current filing process for ETFs is overly redundant and wasteful in terms of costs and use of SEC resources, agrees Kathleen Moriarty, a partner at Katten Muchin Rosenman.

The New York-based lawyer was involved in creation of the first ETF, the SPDR Trust (AMEX: SPY) and consults fund providers as well as government agencies around the world on ETF regulatory issues.

Moriarty says that after 15 years, it only makes sense to streamline the system. "The ETF sponsors don't want to take so much time putting together these 100-page applications that are pretty cut-and-dried," she said. "And on the SEC side, the staff doesn't want to take up their time reading these applications over and over that say the same basic things."

A similar situation took place years ago with money market funds. Those seemingly staid investment products initially weren't permitted under the Investment Company Act of 1940. "So money market funds were forced to go through a whole huge application process like ETFs do today," said Moriarty. "The SEC finally got to a point where they'd seen enough of these types of filings to codify the exemption process."

That's exactly what is happening with ETFs now, she adds. "They've seen enough similarities among applications over the past 15 years to update and streamline the process," said Moriarty.

Trickier Than It Seems

The real question she sees is whether a new process should be extended to active, nonindex-based ETFs. "A lot of people are going to be asking if the SEC has the experience with active ETFs to know if the portfolio transparency issue is going to be sufficiently resolved," said Moriarty.

And that might not be as easy as it first appears.

That debate could very well hold up implementation of any new rules, says Moriarty. "After the first round of comments, the SEC could just decide to cut out active ETFs," she said. "They could narrow the scope of the rules to just index ETFs."

Fuller also doesn't expect the rules to be adopted exactly as proposed. She worked for nearly six years on the SEC staff before leaving last spring. Much of that time was related to regulation of ETFs. "Each of the new rules has some meat of its own," Fuller said. "And the commissioners seem very open to changes."

One of those, the 6c-11 rule, seeks to liberalize the regulatory regime for fully transparent ETFs. That means portfolios made public on a daily basis are covered by the reforms.

The other rule, 12d1-4, is designed to make it easier for hedge funds and mutual funds to invest in ETFs, Fuller says. "It could create additional competition between ETFs and mutual funds," she said.

Fuller says the new rules proposals speed ETFs to market. "But they shouldn't have a substantive effect on the types of ETFs that would've been permitted under the old orders," Fuller said.

If those rules and related amendments are adopted, "ETFs will just have to file a registration statement to launch," she added.

But some analysts and advisors say they're concerned that a debate over timing and other procedural issues will blur what regulators really need to address.

"Active ETFs are going to come out no matter what—that's already in the cards," said Ian Naismith, a partner at Sarasota Capital Strategies. "The real thorn in the SEC's side is going to be how much more difficult those types of products will make it to determine accurate prices."

With index ETFs, holdings are generally held for at least a month. That's due to the fact that they follow preset rules which rebalance portfolios on monthly, quarterly, semiannual or annual bases. "A lot of ETFs don't even change at all unless there's a change in the underlying index," said Naismith. "If a new company comes in or merges, then they'll make a switch."

Quantitative-based ETFs are slightly different than market-cap weighted. "Although they can rebalance much more often, quant-based portfolios are rule-based, making them fairly easy to price every 15 seconds," Naismith said. "But the key is that their portfolios can't change at any time like a truly active ETF."

The wave of active ETFs coming to market will act simply like mutual funds that trade intraday, he added. "The problem we're seeing as managers of client portfolios is in trying to get the absolute best pricing," said Naismith. "When you have a market maker out there with an ETF that's bid/ask price is greater than its intrinsic value, then you're going to find a lot more people paying more for ETFs than they should."

Potential Market Gouging

And that's where real gouging can take place in the market. Naismith fears that many of the worst offenders among mutual fund companies and financial services providers will become more involved when active ETFs become popular.

"They're already seeing movement away from their high-priced mutual funds to ETFs," said Naismith. "It only makes sense that they put out versions of their existing active mutual funds in ETF structures."

That's likely to drive up prices, both in terms of expense ratios charged to investors as well as more problems with fair pricing. "I don't know if they'd make their own markets in ETFs, but there's already regular pricing problems with some existing ETFs," Naismith said. "Unless there's some mandate from the SEC, coming up with fair pricing in ETFs is going to become like the Wild West."

High-volume ETFs such as SPY and iShares Russell 2000 Index (NYSE: IWM) and PowerShares QQQ (NASDAQ: QQQQ) don't pose the real problem, he added. "A lot of the thinly traded ETFs are where fair pricing becomes a big headache," Naismith said. "But it's not all of them, just certain ones."

He added: "With active ETFs that are lightly traded, investors are facing a real dilemma. Right now, we're seeing on a regular basis gaps of 30-40 basis points between bids and actual prices. Once active ETFs start storming the market, there's got to be some sort of fair-pricing mechanism to give diligent advisors and investors a way to see what the correct values are at any given moment."