November 2014
Practice Group:
Investment
Management
SEC Issues Preliminary Denial Notices for Two
Nontransparent Actively Managed ETF Applications
U.S. Investment Management Alert
By Stacy L. Fuller, Mark D. Perlow, and Timothy A. Bekkers
Summary
In 2008, the Securities and Exchange Commission (“SEC” or “Commission”) approved the
first actively managed exchange-traded funds (“ETFs”). 1 The exemptive orders for those
ETFs—and all active ETF exemptive orders since—have required daily portfolio
transparency. 2 On October 21, 2014, the Commission issued notices (“Notices”) on
exemptive applications filed by two separate sets of applicants (the “Applicants”) seeking
relief from the Investment Company Act of 1940, as amended (“1940 Act”), to launch
nontransparent active exchange-traded funds (“NTA ETFs”). 3 In the Notices, the
Commission states that it has “preliminarily” determined to deny the requested exemptions.
This Alert describes the NTA ETFs proposed by the Applicants, summarizes the Notices,
and analyzes significant aspects of the Notices.
The Proposed NTA ETFs
As noted above, to date, active ETFs have provided daily portfolio transparency—meaning
daily disclosure, prior to the opening of trading in their shares, of the ETF’s portfolio holdings
that will be included in the calculation of net asset value (“NAV”) that trading day. 4 The NTA
ETFs proposed by the Applicants would not provide daily portfolio transparency; rather, they
would generally only provide the same disclosures as existing mutual funds do, with one
exception -- the publication of their intraday indicative value (“IIV”) every 15 seconds during
the trading day.
The IIV is an estimated per-share value of an ETF’s portfolio, and all ETFs currently provide
for the calculation and publication of their IIV every 15 seconds during the trading day. The
calculation uses the last-available market quotation of the ETF’s portfolio holdings. The
Applicants argued that the IIV could substitute for the daily portfolio transparency currently
provided by active ETFs. Their argument was based on the premise that, over time, market
makers would discern the relationship between an NTA ETF’s IIV and market movements,
as well as the relationship between the IIV and various financial instruments. Thus, after “a
few days,” the IIV would provide market makers with enough information about the NTA ETF
portfolio to deconstruct the portfolio, construct an appropriate hedging vehicle, and conduct
arbitrage transactions in the NTA ETFs’ shares. The availability of an appropriate hedging
vehicle for an ETF’s shares is important to market makers because it allows them to hedge
their exposure to the ETF, which allows them to make a tighter market in the ETF’s shares.
To conduct redemptions in kind, (as ETFs typically do,) without disclosing the NTA ETFs’
portfolios, and thereby preserve the tax efficiencies of the ETF structure, the Applicants
proposed to employ a “blind trust” for each investor transacting directly with an NTA ETF.
SEC Issues Preliminary Denial Notices for Two
Nontransparent Actively Managed ETF Applications
The blind trust would receive securities in kind in connection with redemptions, then liquidate
them and pay cash to the investor. By using the blind trust, the NTA ETF could make in-kind
distributions of securities without disclosing its portfolio and without recognizing capital gains
under relevant tax laws. 5
Each of the Applicants also proposed a “fail-safe” mechanism, which had not previously
been proposed for usage by an ETF and which was designed to ensure that individual
investors could redeem the NTA ETFs’ shares at NAV, similar to the redemption rights of
mutual fund shareholders. In particular, one set of Applicants proposed to honor all retail
shareholder redemptions on a daily basis, 6 while the other proposed to honor all shareholder
redemptions for 15 days after shares traded at a discount of 5% or more for 10 consecutive
trading days. Both sets of Applicants proposed to impose redemptions fees of up to 2% on
such redemptions to protect shareholders against potentially dilutive transaction costs
incurred by the funds in connection with them. The Applicants also acknowledged that
investors would likely pay brokerage commissions in addition to such redemption fees.
The SEC Notices
In the Notices, the SEC said, “the Commission preliminarily believes that the specific
features proposed by the Applicants that would cause the proposed ETFs to operate without
transparency fall far short of providing a suitable alternative to the arbitrage activity in ETF
shares that is crucial to helping keep the market price of current ETF shares at or close to
the NAV per share of the ETF.” Accordingly, the Commission “preliminarily” concluded that
the exemptive relief requested should be denied.
In reaching this conclusion, the Commission focused on what it described as deficiencies in
the IIV as a primary pricing signal for potential arbitrage transactions. 7 More specifically, the
Commission stated that IIVs are calculated by third parties subject only to standards of
“commercial reasonableness” and susceptible to frequent errors. 8 The Commission also
stated that NTA ETFs themselves take no responsibility for their IIVs, since an IIV is not a
“real-time NAV.” As such, the Commission said, IIVs are not “subject to meaningful
standards” and are “potentially arbitrary and inconsistent,” making it difficult for arbitrageurs
to discern the relationship between them, on the one hand, and market movements and
changes in the value of financial instruments, on the other hand, as necessary to construct a
hedging vehicle and conduct arbitrage. Further, the Commission stated, because IIVs are
based on the last traded price of the NTA ETF’s portfolio holdings and the price of such
holdings can fluctuate dramatically within 15 seconds (the intervals at which the proposed IIV
would be disseminated), IIVs reflect “stale data,” which can lead to poor executions and
thereby discourage arbitrage transactions. 9 These problems would be exacerbated, the
Commission said, in the case of illiquid and foreign securities, which may be fair valued by
the NTA ETF for purposes of calculating NAV but not fair valued for the IIV, and in the case
of stressed (or volatile) markets. Further, the Commission observed that, in meetings with its
staff, market makers had “expressed some skepticism” that the IIV could work as an
arbitrage signal for active strategies that require frequent portfolio turnover; yet the
Applicants proposed active strategies that would normally have significant portfolio turnover.
The Commission also found each Applicant’s fail-safe mechanism “potentially deficient” in
light of what the Commission described as the significant redemption fees and brokerage
commissions attendant to redemptions. Further, the Commission stated: “even if Applicants
were able to address the Commission’s concerns about the [fail-safe mechanism], this would
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SEC Issues Preliminary Denial Notices for Two
Nontransparent Actively Managed ETF Applications
not address the Commission’s more fundamental concerns about Applicants’ proposal.” In
short, the Commission stated, the fail-safe mechanism “does not cure the inherently flawed
structure of the proposed ETFs here.”
Analysis
The Notices are noteworthy as public statements of the Commission’s “preliminar[y]” intent to
deny the requested exemptions. Typically, if the SEC staff intends not to support (or the
Commission intends to deny) an exemptive application, the SEC staff calls the applicant and
suggests that the application be withdrawn. The applicant then typically withdraws the
application. Here, it appears that the Commission sought to use the Notices to make a public
statement about the policies that will guide its consideration of exemptive applications for
NTA ETFs, and such policies appear to be based on the “foundational principle” that “all fund
shareholders be treated equitably when buying and selling their fund shares.”
According to the Commission, this principle derives from section 22(d) of the 1940 Act and
rule 22c-1 thereunder. Section 22(d) generally requires open-ended funds to sell their shares
only at the price set forth in their prospectus, and rule 22c-1, among other things, requires
such funds to employ forward pricing. The Commission stated that, “in granting [ETF]
exemptions to date, the Commission has required that a mechanism exist to ensure that ETF
shares would trade at a price that is at or close to the NAV.” In short, the Commission
suggested that shareholders will not be deemed to be treated equitably in an ETF structure
unless all shareholders can buy and sell shares at approximately the same price.
The Commission’s elevation of this principle explains the Notices’ focus on the proposed
NTA ETFs’ IIV. Although all existing ETFs are required to provide for the calculation and
publication of an IIV, the Notices articulate a critique of the IIV as the “primary” signal for an
arbitrage opportunity. In doing so, the Commission noted that, in practice, arbitrageurs do not
use the IIV for that purpose. Rather, the Commission stated, they primarily use the disclosed
ETF portfolio to signal an arbitrage opportunity, and as there would be no disclosed portfolio
here or other disclosures that the SEC believes would keep the market price and NAV close,
the proposal fell short of what is necessary to obtain the requested exemptions.
The Notices should not be read overbroadly, however, as they do not appear to signal that
the Commission will decline to approve all NTA ETFs. Indeed, other NTA ETF proposals
currently before the Commission propose different arbitrage mechanisms, and the
Commission has not ruled out considering those on a case-by-case basis. Additional insight
into the Commission’s views on NTA ETF structures may come in connection with those
rulings and may still be provided in connection with the Notices, if either of the Applicants
requests a hearing on its Notice. 10 Any hearing request must be received by the
Commission by November 17, 2014. Absent such a request, the SEC will issue orders
denying the applications. As of the time of this Alert’s publication, no hearing request had
been publicly filed.
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SEC Issues Preliminary Denial Notices for Two
Nontransparent Actively Managed ETF Applications
Authors:
Stacy L. Fuller
Mark D. Perlow
Timothy A. Bekkers
stacy.fuller@klgates.com
+1.202.778.9475
mark.perlow@klgates.com
+1.415.249.1070
timothy.bekkers@klgates.com
+1.202.778.9443
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1
E.g., PowerShares Capital Management LLC, et al., Investment Company Act Release Nos. 28140 (Feb. 1,
2008) (notice) and 28171 (Feb. 27, 2008) (order).
2
See, e.g., Grail Advisors, LLC, et al., Investment Company Act Release Nos. 28571 (Dec. 23, 2008) (notice)
and 28604 (Jan. 16, 2009) (order) at condition 8 (“On each Business Day, before the commencement of trading in Shares
on the Fund’s Listing Exchange, the Fund will disclose on its Website the identities and quantities of the Portfolio
Securities held by the Fund that will form the basis for the Fund’s calculation of NAV at the end of the Business Day”); and
Calamos Advisors LLC, et al., Investment Company Act Release Nos. 30628 (July 24, 2013) (notice) and 30653 (Aug. 20,
2013) (order) at condition A.4.
3
Precidian ETFs Trust, et al., Investment Company Act Release No. 31300 (Oct. 21, 2014) and Spruce ETF
Trust, et al., Investment Company Act Release No. 31301 (Oct. 21, 2014). In a closely related development, the SEC also
rejected the rule change proposed by the NYSE Arca, Inc., under Rule 19b-4 of the Securities Exchange Act of 1934, as
amended, to list the NTA ETFs proposed by Precidian.
4
Due to fund accounting practices, all trades executed through and including the prior trading day must be
included in the disclosure.
5
Applicants proposed for the NTA ETFs to sell creation units of shares for cash as in-kind creations (unlike inkind redemptions) provide no tax benefits.
6
Precidian defined a retail investor as a “beneficial owner that is an individual, trust exclusively for the benefit of
an individual or group of related family members, or a tax deferred retirement plan directed by an individual.”
7
In support of its conclusion, the Commission cited various sources, including many books and articles and
comment letters that the Commission received in connection with the Actively Managed ETF Concept Release,
Investment Company Act Release No. 25258 (Nov. 8, 2011), including comment letters submitted by Applicants
themselves, which called into question the value of the IIV.
8
The Commission noted that “an IIV that is sufficiently accurate and precise” may present a different set of
problems, as it “may enable third parties to reverse engineer the [ETF] portfolio.”
4
SEC Issues Preliminary Denial Notices for Two
Nontransparent Actively Managed ETF Applications
9
The Commission noted that disseminating IIVs more frequently “could present a different set of problems, as it
may enable third parties to reverse engineer the [ETF] portfolio.”
10
The Commission is likely to regard only the Applicants as having standing to request a hearing on their
respective Notices. See, e.g., Vanguard Index Funds, et al., Investment Company Act Release Nos. 24680 (July 12,
2000) (notice) and 24789 (Dec. 12, 2000) (order).
5