Investment Management Alert

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1 February 2008 Authors: Stacy Fuller Richard M Phillips richard.phillips@klgates.com K&L Gates comprises approximately 1,500 lawyers in 24 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit SEC Green-Lights First Actively Managed ETFs Introduction Two weeks ago, the SEC signaled that it is ready to approve the first actively managed exchange-traded funds ( ETFs ). As a result, such ETFs can be expected to be up and running by the end of this month. This alert identifies some of the key differences between these new ETFs and their indexbased predecessors as well as the potential issues created by such differences. It identifies the sponsors of the actively managed ETFs that have received the green light from the SEC and briefly describes each of their products. The alert closes with a few observations on the market s and the industry s possible reaction to these new ETFs. Background Since their debut in 1993, ETFs have climbed to unanticipated heights in the fund world. Consider the following in measuring ETFs ascent. In 1993, there was one ETF with less than a half billion dollars in assets under management ( AUM ). At the end of 1999, there were 30 ETFs with approximately $33 billion AUM. By the end of 2007, there were approximately 650 ETFs with $700 billion AUM, and average daily trading volume in ETFs reached $72 billion on $875 million shares. 1 Notably, this growth has been achieved exclusively by index-based ETFs meaning ETFs whose objectives are to track the performance of an index. The rather impressive figures above raise at least two questions. First, how much more would ETF assets have grown if actively managed versions had also been launched? And why haven t actively managed ETFs been launched until now? The delay in the launch of actively managed ETFs is a function of the ETF structure and ETF operations. An ETF is a cross between a traditional mutual fund and a closed-end fund. Like a closed-end fund, an ETF s shares trade on an exchange, so investors may purchase and sell them throughout each trading day at a market price that is influenced by the supply of and demand for them, as well as by the net asset value ( NAV ) of the ETF. Unlike closed-end funds, however, ETFs may also transact at NAV with large investors on a daily basis in large blocks of redeemable shares, which are known as Creation Units. In this regard, ETFs are more like traditional mutual funds than closed-end funds. In other respects, ETFs are not like either open-end or closed-end funds. For example, they generally sell and redeem Creation Units on an in-kind basis in exchange for a basket of securities ( Basket ), rather than for cash as do most open-end and closed-end funds. In addition, they provide full portfolio transparency both by making a daily posting on their 1 See Joe Morris, New-ETF Euphoria Wanes, ignites.com, January 2, 2008.

2 website of their portfolios and, generally speaking, by designating Baskets that are pro rata slices of their portfolios. 2 Together, the open-end and closed-end features of ETFs create a unique arbitrage mechanism that is fueled by full portfolio transparency. Given full portfolio transparency, investors can determine at any time on any trading day the approximate NAV of an ETF and compare that figure throughout the day to the market price of the ETF s shares. 3 To the extent that there is a discrepancy between NAV and market price, arbitrageurs can profit by purchasing the ETF shares on the market and redeeming them at NAV (when the market price of the ETF shares is less than the NAV) or by purchasing Creation Units of shares at NAV and selling them in the market (when the NAV is less than the market price). 4 Such arbitrage transactions in an ETF s shares keep their market price in line with the ETF s NAV and keep an ETF s shares from consistently trading at a significant discount to NAV. They also allow all investors, whether transacting in the secondary market or at NAV, to buy and sell ETF shares at a price that reflects only a small spread between the bid and the ask. Because arbitrage transactions are critical to an ETF s successful operation and because they depend on full portfolio transparency, the ETF structure has posed something of a dilemma for active managers who believe that their investment strategies would be negatively impacted by full portfolio transparency. For this reason, active managers who may want to respond to investors enthusiasm for ETFs may also 2 ETFs disclose the Baskets via a portfolio composition file or PCF sent to their listing exchange and/or DTC/NSCC prior to the opening of the exchange on the day that the Basket will be used for Creation Unit transactions. 3 This figure, which is widely referred to as the intraday indicative value or IIV, is published by the ETF s listing exchange at 15-second intervals throughout the day. 4 Investors who engage in ETF arbitrage must have the financial wherewithal to transact in Creation Units, which generally consist of 50,000 ETF shares. Such investors usually do not wait for the ETF to calculate its NAV at market close to determine the size of their arbitrage profit. Rather, they simultaneously transact with the ETF and enter into a variety of derivative transactions, which permit them to lock in an arbitrage profit equal to the difference between the market price and the NAV of the ETF s shares at the time of their simultaneous trades. harbor concerns about the ability to achieve alpha while accommodating the SEC s insistence on full portfolio transparency. The First Actively Managed ETFs The actively managed ETFs that were recently greenlighted by the SEC are subject to three new conditions, each of which is discussed below in detail. Full Portfolio Transparency Condition. The most significant condition of the exemptive orders on which the newest ETFs will rely requires them to provide full portfolio transparency. 5 That condition, which appears in each of the SEC notices issued, provides as follows: On each [b]usiness [d]ay, 6 before commencement of trading in [ETF] [s]hares on the Exchange, 7 the [ETF] will disclose on its website the identities and quantities of the [p]ortfolio [s]ecurities and other assets held by the [ETF] that will form the basis for the [ETF] s calculation of NAV at the end of the [b] usiness [d]ay. The SEC will likely impose the same condition and require full portfolio transparency of all ETFs that seek to launch in this first wave of actively managed ETFs. In connection with this new condition, as the SEC explained in each of the notices issued last week, under accounting procedures followed by the [ETFs], trades made on the prior business day ( T ) will be booked and reflected in NAV on the current business day ( T+1 ). Accordingly, the SEC noted, the ETFs need not disclose any trade made for an ETF portfolio on the day that it is made; rather, they have until the 5 Because ETFs are neither wholly open-end funds nor wholly closed-end funds, there is no natural regulatory regime for them in the Investment Company Act of 1940 ( Act ) and, therefore, they cannot operate without an order from the SEC exempting them from various provisions of the Act. The process of obtaining an exemptive order involves filing an exemptive application and engaging in a lengthy process of working with the SEC staff to produce an exemptive application acceptable to the staff before a notice and order of the application is published in the Federal Register. 6 Business day means any day that the ETF is open, including as required by Section 22(e) of the Act. 7 Exchange means a national securities exchange, as defined by Section 2(a)(26) of the Act. February

3 opening of trading on the day after the trade to disclose its effect on the ETF portfolio. Thus, the manager of an actively managed ETF can shield from the public view trades made for the fund for up to one business day. This same trade-then-disclose process is currently used by index-based ETFs. That is, when an indexbased ETF executes a trade for its portfolio due to, for example, an index rebalancing or a corporate event that causes one of its index s constituents to leave the index, the ETF effectuates the change by trading on T and disclosing the trade s effect on the portfolio on T+1. This is the same trade-then-disclose process approved by the SEC for the new, actively managed ETFs. Although this trade-then-disclose process is already used by index-based ETFs, its use by actively managed ETFs is novel. Because it only shields the effects of a manager s trading for one business day, however, its usefulness may be limited for most advisers. We note, however, that portfolio managers in a multimanager ETF may be able to diffuse the impact of the SEC s full transparency requirement. They are able to do so because the changes they make for their slice of the ETF portfolio are only disclosed within the context of the portfolio as a whole. As a result, while there is the requisite transparency into the ETF portfolio as a whole, there is no direct transparency into the strategies of any individual manager of the multi-manager ETF. Indirect Violation Condition. A second new condition imposed by the SEC on the first generation of actively managed ETFs reminds their managers of the restrictions imposed on them by Section 48(a) of the Act. Section 48(a) makes it unlawful for any person, directly or indirectly, to cause to be done any act or thing through or by means of any other person which it would be unlawful for such person to do under the Act. Similarly, the second new condition for actively managed ETFs provides, The [ETF s] [a]dviser[s], directly or indirectly, will not cause any [third party] to acquire any [s] ecurity for the [ETF] through a transaction in which the [ETF] could not engage directly. This condition is arguably redundant inasmuch as it merely prohibits behavior already prohibited by Section 48(a). The SEC staff, however, may consider this condition to be important insofar as it addresses one of the most novel aspects of actively managed ETFs: such ETFs may transact in kind in issuing Creation Units, and any restrictions in the Act that limit their ability to purchase certain securities, such as those of securities-related issuers, would not obviously apply to purchases by investors of such securities for deposit with the ETF in exchange for Creation Units. 8 Because the policy concerns are no different, however, whether such ETFs are buying the securities directly or having investors buy them and deposit them in exchange for Creation Units, the restrictions in the Act on the ability of the ETFs to create demand for such securities should be no different. This condition clarifies that point. ETF Rule Condition. The final new condition imposed on first generation actively managed ETFs provides as follows: The requested order will expire on the effective date of any Commission rule under the Act that provides relief permitting the operation of actively managed exchange-traded funds. This condition implies that the SEC, possibly in the foreseeable future, will propose a rule to permit actively managed ETFs to become operational without going through the time-consuming exemptive applications process. 9 Although the Director of the Division of Investment Management had previously acknowledged that his staff was working on an ETF rule, prior to the inclusion by the SEC of this condition in the recent ETF notices there had been no indication that the contemplated rule would extend to actively managed ETFs. 10 Rather, it was generally assumed that the ETF rule to be proposed would cover only index-based ETFs. Last week s notices, however, indicate that the ETF rule on 8 This issue does not arise with respect to index-based ETFs because all index funds, regardless of their organizational structure (as ETFs or otherwise), may purchase such securities in reliance on a series of no-action letters issued by the SEC staff. E.g., Select Sector SPDR Fund (pub. avail. July 6, 2000). 9 The rule has not yet been proposed, and there is no known timetable for its proposal. We expect the rule, as ultimately proposed, to cover then-routine ETF products, including indexbased ETFs and perhaps first generation actively managed ETFs of the type and subject to the conditions described herein. Actively managed ETFs that deviate from any aspect of the rule will continue to require exemptive orders. 10 See Andrew Buddy Donohue, Remarks Before the Investment Company Institute 2007 Operations and Technology Conference (Oct. 18, 2007). February

4 which the SEC staff is working will likely include at least some actively managed ETFs. The First Generation of Actively Managed ETFs. Based on the SEC notices issued two weeks ago, PowerShares Capital Management, Bear Stearns Asset Management, Barclays Global Fund Advisors and WisdomTree Asset Management should be first out of the gate with actively managed ETFs. (To review the notices issued, go to rules/icreleases.shtml.) The funds that each intends to introduce are as follows: PowerShares proposes to launch four ETFs, including three equity and one fixed income product. Two of the equity funds will use a quantitative screening methodology developed by their subadviser to select securities for their portfolio; the other equity fund will employ more traditional portfolio management techniques. The fixed income fund will invest in U.S. government and corporate debt securities. All four ETFs will generally conduct Creation Unit transactions in kind. Bear Stearns proposes to launch one ETF that invests primarily in investment grade (or comparable) fixedincome securities. The fund will sell and redeem Creation Units in cash. Barclays proposes to launch two ETFs, each of which will invest in foreign money market securities denominated in the local currency specified in the name of the fund. The value of each fund s shares will be relatively constant in local currency terms, but inversely reflect changes in the value of the U.S. dollar vis-à-vis the local currency. Each of the Barclays ETFs will generally sell and redeem Creation Units in the local currency but may accept in-kind deposits of securities denominated in the local currency. WisdomTree proposes to launch eight ETFs, five of which will invest in foreign money market securities denominated in the local currency specified in the name of the fund and three of which will invest in U.S. money market securities. The value of each fund s shares will be relatively constant in local currency terms (whether the local currency is a foreign currency or the U.S. dollar); the value of the funds that invest in foreign money market securities, however, will inversely reflect changes in the value of the U.S. dollar vis-à-vis the local currency. Each of the WisdomTree ETFs will generally sell and redeem Creation Units in the local currency but may accept in-kind deposits of securities denominated in the local currency. Observations on First-Generation and Next-Generation Actively Managed ETFs The sponsors of the actively managed ETFs described above must be commended for pushing the envelope of innovation and obtaining approval from the SEC for their financial products. Their efforts have likely opened the door for the even more innovative products that are sure to follow. While no one knows what the next generation of actively managed ETFs will look like, we offer the following observations on the ETF structure and the ETF marketplace. With respect to the ETF structure, ETFs have historically conducted Creation Unit transactions in kind, as noted above. In so doing they have avoided certain taxes that traditional mutual funds incur as a result of transacting in cash. Some of the first-generation actively managed ETFs, however, will abandon the in-kind approach and transact solely in cash. It remains to be seen what effect if any an all-cash approach will have on the tax efficiencies traditionally associated with ETFs. To the extent that redemptions of their Creation Units are honored in cash and, therefore, necessitate sales of portfolio securities, we would expect their tax situation to be more like that of traditional mutual funds than that of previous ETFs. This may diminish their appeal for those investors, who have chosen ETFs in the past due to their tax advantages, and providers of actively managed ETFs may want to follow this development. Providers of actively managed ETFs should also prepare to deliver a prospectus in connection with each secondary market transaction in such ETFs shares. 11 Although the SEC has granted index-based ETFs exemptive relief from Section 24(d) of the Act to permit them to treat secondary market transactions in ETF shares like secondary market transactions in closed-end 11 As open-end investment companies, ETFs should be able to satisfy any prospectus delivery requirement with a summary prospectus, if the SEC s recent summary prospectus rule is adopted. Investment Company Act Release No (Nov. 21, 2007). February

5 fund shares, which do not necessitate the delivery of a prospectus, similar relief is not contemplated by the notices issued last week for the first actively managed ETFs. The absence of such relief in the notices could be a function of PowerShares, Bear Stearns, Barclays and WisdomTree not seeking such relief. Alternatively, the SEC may have hesitated to approve such relief for actively managed ETFs out of concerns about investor confusion (between traditional actively managed funds and actively managed ETFs) or leveling the playing field between such traditional mutual funds and their new, actively managed ETF competitors. Regardless of the reason for such relief not being included in last week s notices, to the extent that a future provider of actively managed ETFs desires such relief, it will fall to that provider to push it through the SEC. Finally, with respect to the ETF marketplace, the importance to date for ETFs of appealing to financial advisors cannot be overstated. Many (if not most) investors who currently invest in ETFs do so through financial advisors. The financial advisors with whom index-based ETFs have been most popular are those who traditionally select individual stocks for client portfolios and either use ETFs to invest in market niches (e.g., India) or use a combination of sector ETFs and individual stocks to implement an asset allocation strategy. Such advisors, thus, have effectively used index-based ETFs in order to obtain particular exposures in their clients portfolios. These financial advisors may not embrace actively managed ETFs as they have index-based ETFs because such funds will not play the same role in a client s portfolio. Other financial advisors, however, likely will embrace actively managed ETFs. In this camp of financial advisors are those who have not typically invested their clients portfolios in individual stocks, but rather in mutual funds and closed-end funds. These advisors, who in the past have recommended particular managers and their funds to their advisory clients, may instead turn to actively managed ETFs. In this way, actively managed ETFs will compete more directly with traditional managed funds. In competing, actively managed ETFs should be expected to market, among other things, the ability to buy and sell their shares at intra-day prices on an exchange, any tax advantages of their structure and the transparency of their portfolios. The question that actively managed ETFs will need to answer is whether, given the need for portfolio transparency, they can develop into an alternative to the traditional mutual fund across the various asset classes, particularly those in less liquid markets. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis - Taiwan Commercial Law Offices) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@klgates. com if you would prefer not to receive this information Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. February