Exchange-Traded Funds ( ETFs ): A Director s Guide. Nicole M. Crum Eric Simanek April 27, 2017

Transcription

1 Exchange-Traded Funds ( ETFs ): A Director s Guide Nicole M. Crum Eric Simanek April 27, 2017

2 Presentation Overview What is an ETF? What are the advantages of ETFs over mutual funds? What are an ETF Board s responsibilities? Board oversight of ETFs Required Board approvals Quarterly materials requests 15(c) process Compliance program Firm resources 2

3 What is an ETF? ETFs are open-end management investment companies that trade throughout the day on securities exchanges (such as NYSE Arca). ETF shares will trade at the market price on the relevant exchange, rather than at NAV. ETF shares may only be purchased or redeemed at NAV directly from the fund in large blocks (e.g., 50,000) called Creation Units. Direct purchases or redemptions of Creation Units from an ETF may only be done by Authorized Participants. 3

4 Most Common Types of ETFs Index-Based Actively Managed Smart Beta Strategy 4

5 Purchases and Redemptions Purchases and redemptions of Creation Units are typically effected in-kind in exchange for a specified basket of securities and/or other assets (the Creation Basket ). ETFs effect purchases and redemptions of Creation Units by or through Authorized Participants. Authorized Participant: Typically a large financial institution (e.g., Citi, Merrill, etc.) that enters into an agreement that allows it to purchase and redeem shares directly from the ETF. 5

6 Arbitrage Mechanism The ability to purchase and redeem ETF shares at NAV, along with the separate and continuous trading on the exchange, creates the ability to arbitrage ETF shares, which has the effect of keeping the market price of ETF shares close to NAV per share. Portfolio transparency allows arbitrage to function effectively by allowing market participants to identify discrepancies between the market price and estimates of the value of the ETF portfolio securities. 6

7 What are the advantages of ETFs Over Mutual Funds? Liquidity Trading Control Lower Costs Tax Efficiency 7

8 Legal Hurdles ETFs are typically required to seek exemptive relief from certain provisions of the Investment Company Act of 1940 ( 1940 Act ). ETFs may also require relief from certain provision of the Securities Exchange Act of 1934 and the rules thereunder. ETFs must follow Exchange Listing Standards. 8

9 What are the responsibilities of an ETF Board? The responsibilities of ETF Trustees are substantially similar to those of mutual fund Trustees. ETF Trustees have a fiduciary duty to the ETF and serve to protect the interests of ETF shareholders. There are some differences in an ETF s Board s oversight process in light of the unique aspects of the ETF s structure and operations. ETFs are subject to additional requirements, such as requirements imposed by the exchange on which the ETF s shares are traded and requirements imposed by the SEC exemptive relief which permits the ETF to operate, as well as Board considerations regarding ETFspecific operational issues. 9

10 Board Oversight of ETFs Required ETF Board Approvals Quarterly Materials Requests 15(c) Process Compliance Program Resources 10

11 Required ETF Board Approvals Board approvals generally track those of a mutual fund; however, ETF-specific approvals are required. Standard mutual fund approvals must be made with ETF-specific operational considerations based on appropriate information and materials from management and service providers. 11

12 Board Oversight of ETFs Quarterly Materials Requests To oversee the ETF s trading, it is helpful for an ETF Board to receive quarterly: regular reports regarding Authorized Participant contracts and activities, creation/redemption transactions, premiums and discounts, bid-ask spreads, tracking error, transactions with affiliated persons, and trading volume; reports on the number of Authorized Participants, the number of market makers, and their trading volumes, so the Board is familiar with their activities in making markets for the ETF shares; and a summary of applicable exchange and exemptive order requirements and an explanation regarding how the requirements are being met. 12

13 15(c) Process The 15(c) process for ETFs is similar to the process for other mutual funds; however, the 15(c) process for ETFs should address the unique ETF structural and operational attributes. With respect to Directors who are adding ETFs to their fund lineup, the 15(c) materials should be enhanced. 13

14 15(c) Process Sample Enhancements Update the 15(c) request letter to include ETF-specific questions relating to service providers, performance, distribution, fees, compliance, etc. Tailor the Board s consideration of the 15(c) components to ETFs (for example, performance can be evaluated differently). Include a description of ETF-specific services provided by the Adviser and other service providers to explain and document the services provided for the fees paid. 14

15 15(c) Process Sample Enhancements (continued) Request that management include cover memoranda on the reports which include an analysis of the data and whether management is comfortable with the data. Request Board educational sessions on the ETF strategies in your complex and operational issues of interest from management and independent legal counsel. 15

16 Compliance Program ETF Boards, like mutual fund boards, must approve compliance programs for the ETF and its service providers. ETF compliance programs should address compliance with ETF exemptive relief. ETF compliance policies and procedures will differ from other fund policies and procedures. Monitoring trading information (premiums/discounts, bid/ask spreads) Portfolio holdings disclosure Valuation Often no frequent trading policy No retail customers for data privacy and AML requirements Procedures required by exemptive relief from 1940 Act Section 12(d)(1) 16

17 Firm Resources The resources required to launch and operate ETFs are significant. Consider meeting with your Chief Compliance Officer, investment management personnel, operations team and firm management in executive sessions to discuss the resources available to support the ETFs and whether resources are adequate. Consider use of third-party providers to leverage their resources and expertise, particularly at the outset of launching ETFs. 17

18 Do not be afraid to ask questions! 18

19 Appendix Key Structural ETF Attributes and Board Oversight 19

20 Key Structural ETF Attributes and Board Oversight ETF Attribute Board Oversight Implications ETFs require SEC exemptive relief to operate which imposes requirements on operations and Board oversight. Trustees should understand/consider: General provisions of exemptive relief The processes in place to ensure compliance with the requirements of the exemptive relief Responsibilities imposed on Boards (e.g., relating to Funds of Funds and ETFs with affiliated index providers.) 20

21 Key Structural ETF Attributes and Board Oversight Implications ETF Attribute Board Oversight Implications ETF shares are bought and sold on a stock exchange at market-quoted prices throughout the trading day, and the value of ETF shares may deviate from the market value of the underlying investments. An ETF Board may receive the following information regarding fund trading: Summary of creation/redemption transactions Premium/discount information Bid/ask spread information, which is also an important element of the cost to ETF shareholders. 21

22 Key Structural ETF Attributes and Board Oversight Implications ETF Attribute Board Oversight Implications ETFs effect purchases and redemptions of Creation Units by or through Authorized Participants. The arbitrage mechanism is designed to ensure that ETF shares trade close to NAV. The Board should understand the processes for creating and redeeming ETF Creation Units. In-kind vs. cash creations/redemptions Liquidity of underlying portfolio securities 22

23 Key Structural ETF Attributes and Board Oversight Implications ETF Attribute Board Oversight Implications Investors purchase shares on the secondary market through an exchange. Exchange requirements, including corporate governance provisions, apply to ETF operations. The requirements for ETFs are typically fewer than those applicable to closed-end funds. The Board should confirm that management is fulfilling the requirements imposed by the exchange. Board Composition Notification Requirements Listing Standards Initial Listing Standards Continued Listing Standards 23

24 Key Structural ETF Attributes and Board Oversight Implications ETF Attribute Board Oversight Implications Daily, the website must contain certain information regarding portfolio holdings and/or the composition of the Creation/Redemption Basket. The Board should confirm that management has a process for ensuring this information is accurately and timely posted and that the proper process is followed. 24

25 Key Structural ETF Attributes and Board Oversight Implications ETF Attribute Board Oversight Implications Index ETFs may experience tracking error. The Board should understand the ETF s investment strategy and why tracking error occurs, such as return differences due to fees, regulatory requirements, or unavailability of certain securities. Board should understand when the manager will use a representative sampling strategy. 25