Exchange-Traded Funds: The Current Landscape and Relevant Board Considerations

Transcription

1 Exchange-Traded Funds: The Current Landscape and Relevant Board Considerations Michael W. Mundt November 1, 2012 This presentation is for educational purposes only. It should not be construed as legal advice or opinion or as a substitute for the advice of counsel Stradley Ronon Stevens & Young, LLP

2 What is an Exchange-Traded Fund (ETF)? Open-end fund or unit investment trust registered under Investment Company Act of 1940 (1940 Act) Issues and redeems shares in large aggregations only (Creation Units) Transacts directly with Authorized Participants (APs) Creation Unit purchases / redemptions are generally in exchange for specified portfolio securities (Deposit Basket / Redemption Basket) ETF shares are listed on a national securities exchange and trade in secondary market 5

3 ETF Structure and Arbitrage Because shares trade at market price and can be purchased / redeemed (in Creation Units) at NAV from the ETF If market price is below NAV (discount), buy shares in secondary market and redeem at NAV; If market price is above NAV (premium), create shares at NAV and sell shares in secondary market. Arbitrage (or potential for arbitrage) keeps market price close to NAV 6

4 ETF Advantages Cost efficiency: shareholder services at broker level rather than fund level; in-kind transactions may reduce portfolio transaction costs Tax efficiency: in-kind redemptions can allow fund to avoid realizing capital gains Trading flexibility: intraday trading, shorting, other trading strategies available Distribution expenses Transparency 7

5 ETF Caveats Market price may deviate from NAV Index ETFs may have tracking error Tax efficiency is not a given Bid / ask spreads and commissions Understand investment objectives 8

6 Other Types of Exchange- Traded Products Exchange-traded Notes (ETNs) Unsecured debt obligation of issuer Not based on portfolio of securities Risk exposures include creditworthiness of issuer Commodities Trusts Trusts that hold physical commodities Trusts that hold futures 9

7 Regulatory Process: Exemptions under 1940 Act To permit ETF operations, ETF sponsor must obtain exemptive order 1940 Act Application filed publicly on EDGAR Reviewed by Division of Investment Management Routine applications: 12 months Exemptive relief includes: 2(a)(32) / 5(a)(1): allows registration as open-end fund although individual shares cannot be redeemed 22(d) / rule 22c-1: permits open-end fund shares to trade at prices other than NAV 10

8 Regulatory Process: Exemptions under the 1940 Act (cont d) 17(a): allows in-kind transactions with Authorized Participants that are affiliated persons due to ownership of ETF shares 22(e): allows delayed in-kind redemptions for certain ETFs with foreign securities 12(d)(1): allows other investment companies to make significant investments in underlying ETFs Orders usually cover future ETFs advised by same investment adviser Terms and conditions of relief vary depending on type of ETF: unaffiliated index-based; affiliated indexbased; leveraged; actively managed 11

9 Standard Terms and Conditions for ETF Orders All ETFs Must be listed on national securities exchange Cannot be advertised as open-end fund Website disclosure of premium / discount Affiliated index ETFs Firewalls between advisory / index personnel Objective / transparent rules Unaffiliated calculation agent Active ETFs: full portfolio transparency 12

10 Regulatory Process: Registration Registration under the 1940 Act Open-end ETFs register on Form N-1A under 1940 Act Amendments to Form N-1A in 2009 added disclosure provisions specifically related to ETFs Reviewed by Division of Investment Management Registration under Securities Act of 1933 Other exchange-traded products register under 1933 Act only Registration statements reviewed by Division of Corporation Finance 13

11 Regulatory Process: Listing Exchanges must list each ETF before it can trade Generic listing standards exist for index-based ETFs Allows exchange to list index-based ETFs meeting certain criteria with only a notification to SEC Actively managed ETFs can only be listed after specific approval by Division of Trading and Markets on basis of listing application submitted under rule 19b-4 under Securities Exchange Act of

12 ETF Board Duties and Considerations ETF boards have same duties as traditional mutual fund boards, but unique ETF operations can lead to some different considerations: Compliance with ETF order / listing requirements In-kind transactions with affiliated persons Frequent creations / redemptions High level of portfolio transparency Premium / discount concerns Evaluating performance Distribution / shareholder servicing arrangements 15

13 Fund Investments in ETFs Mutual fund investments in ETFs are subject to fund of fund restrictions of 1940 Act Standard restriction: Section 12(d)(1)(A) Investing fund cannot acquire more than 3% of outstanding shares of ETF Investing fund cannot invest more than 5% of its total assets in an ETF, or more than 10% of its total assets in ETFs generally Exemptions: Section 12(d)(1)(F) or (G) 16

14 Exemptive Relief for Funds to Invest in ETFs ETFs obtain relief to permit a registered fund to purchase up to 25% of the ETF s shares Relief subject to terms and conditions: Investing fund must execute agreement with underlying ETF Boards of investing fund and underlying ETF each have duties under orders 17

15 Key Terms and Conditions to Fund of ETFs Relief Investing fund board: Must adopt procedures to ensure that investing fund adviser invests without taking into account consideration from ETF or ETF affiliates Must find that investing fund advisory fees are for services that are not duplicative ETF board: Board must make certain findings regarding services and transactions between underlying ETF and investing fund and investing fund affiliates 18

16 Current Issue: Derivatives Moratorium SEC press release March 2010: SEC staff conducting review of use of derivatives by mutual funds, ETFs and other investment companies Pending completion of review, SEC staff deferring consideration of exemptive requests to permit ETFs that would make significant investments in derivative. Applications for actively managed ETFs move forward only if they include representation that the ETFs will not invest in options contracts, futures contracts or swap agreements 19

17 Concept Release on Use of Derivatives Requested comment on range of issues, including how ETFs use derivatives and any unique investor protection concerns Numerous comments asked for moratorium to be lifted: Noted that moratorium is anti-competitive ETFs with orders that predate moratorium can continue to introduce new ETFs Noted that ETFs use derivatives in same way as other open-end funds and subject to same regulation Noted that staff implementation of moratorium has been more sweeping than originally suggested with respect to actively managed ETFs Noted that no timetable on completion of derivatives review 20

18 ETF Exemptive Rule Rule 6c-11 proposed in March 2008: received about 25 generally favorable comments, but... financial crisis in 2008 reshapes rulemaking agenda concerns about investor confusion and market volatility concerns about spreads on ETF trading / tracking error Flash Crash of May 6, 2010 critical reports from research and foreign regulatory groups 21

19 SEC Scrutiny of ETFs October 2011 SEC testimony: staff from across multiple Divisions and Offices engaged in general review of exchange-traded products (ETPs): adequacy of investor disclosure liquidity levels and transparency of underlying instruments fair valuations efficiency of arbitrage process relationship between market volatility and ETPs March 2012 testimony on SEC budget: ETF activities raise significant disclosure, conflict of interest, market structure, and macro-prudential issues 22

20 Less Transparent Actively Managed ETFs Exemptive relief to permit actively managed ETFs currently requires full portfolio transparency Some active managers concerned that transparency could reveal too much about portfolio management Several applications have been filed for relief to introduce less transparent actively managed ETFs key challenge: provide information that would allow market participants to trade shares efficiently but not enough information to reveal portfolio contents 23

21 Less Transparent Actively Managed ETFs (cont d) Proposed solutions: Real time dissemination of portfolio values (BlackRock 2011) Tracking portfolio (Claymore 2008) Correlated baskets (Vanguard 2007) Real time dissemination of portfolio values 15 second dissemination of intraday price based on actual portfolio Blind trust mechanism to allow for in-kind redemptions Small allotment redemption option if discount develops 24

22 Less Transparent Actively Managed ETFs (cont d) Tracking portfolio Software derives risk characteristics of actual portfolio Characteristics applied to same universe of securities to generate a tracking portfolio Tracking portfolio is not the same as the actual portfolio, but generates similar performance Correlated baskets Similar to existing practices for index ETFs In-kind basket is a subset of actual portfolio with similar performance 25

23 ETF / Mutual Fund Hybrid Eaton Vance is reportedly developing a new product the exchange-traded managed fund (ETMF) Envisions dealer market for mutual fund shares where dealers trade fund shares at spreads to NAV Proposal reportedly would allow for structure where dealers would not need portfolio transparency because intraday prices would not attempt to approximate portfolio value 26

24 Future Growth Prospects for ETFs Structural solutions for building critical mass Master-feeder structure Mutual fund conversion Exchange-traded class Distribution channels Growth of active ETF market 27

25 Contact Information Michael W. Mundt Partner Stradley Ronon Stevens & Young, LLP 202 / mmundt@stradley.com 28