ACTIVELY MANAGED ETFS: THE PAST, PRESENT, AND FUTURE. John Yoder Bo J. Howell

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1 ACTIVELY MANAGED ETFS: THE PAST, PRESENT, AND FUTURE John Yoder Bo J. Howell I. INTRODUCTION II. ETF MECHANICS AND ARBITRAGE EFFICIENCY III. REGULATION OF ACTIVELY MANAGED ETFS A. Organization of ETFs B. Exemptions from the Investment Company Act C. ETF Index Tracking and Variations in Portfolio Disclosures D. The Actively Managed Exchange Traded Fund Concept Release E. Actively Managed ETF Exemptive Orders Daily Full Portfolio Disclosure Sales and Marketing Disclosures Section 48(a) Statement ETF Rule F. The Proposed ETF Rule G. Disclosure Issues and Amended Form N-1A H. Use of Derivatives by Actively Managed ETFs I. Fully Transparent Versus Non-Transparent Actively Managed ETFs IV. LOOKING AHEAD: THE FUTURE OF ACTIVELY MANAGED ETFS A. Costs and Benefits of Actively Managed ETFs Transparency and Liquidity Tax Efficiencies, Transaction and Operating Costs, Management Fees, and Spreads B. Attracting Assets V. CONCLUSION I. INTRODUCTION Actively managed exchange-traded funds ( ETFs ) seek to achieve their investment objectives by pursuing active management investment John Yoder is Vice-President and Assistant Counsel at OppenheimerFunds, Inc. Prior to joining the firm, Mr. Yoder worked in the Division of Investment Management at the U.S. Securities & Exchange Commission, where he was involved with several novel ETF issues. Bo Howell is Assistant Vice President & Counsel at Western & Southern Financial Group. Prior to joining the firm, Mr. Howell worked in the Division of Investment Management in the Office of Disclosure and Review and in the Office of Enforcement Liaison.

2 232 Journal of Business & Securities Law [Vol. 13 strategies. Actively managed ETFs may target a specific asset class such as public securities, bonds, real estate, et cetera but, because they do not track indices, they do not have restrictions on the timing and frequency of their trading strategies. 1 Bear Sterns created the first actively managed ETF in May 2008, which invested in bonds, 2 however, it was liquidated just five months later. 3 In 2009, the first equities-based actively managed ETF began trading. 4 Currently, there are 37 actively managed ETFs in operation. 5 Since the creation of the first ETF in the early 1990s, the ETF industry has exploded in popularity and assets under management. Between June 2003 and February 2006, the number of ETFs more than doubled while ETFs market capitalization increased threefold. 6 This rapid expansion continued through the recent financial crisis. By June 2009, the industry included 720 ETFs with a market capitalization of $550 billion. 7 This represents a 327% growth in the number of ETFs and a 183% growth in market capitalization. By December 2012, the number of ETF assets under management in the U.S. rose to $1.34 trillion. 8 This article discusses the development of actively managed ETFs, their regulation by the U.S. Securities & Exchange Commission ( SEC ), and their costs and benefits. Actively managed ETFs are part of a new wave of ETFs, including those that use inverse, leveraged, target date, and hedge fund strategies. 9 This article focuses on actively managed ETFs registered under the Investment Company Act of 1940 ( Investment Company Act ), as opposed to those registered solely under the Securities Act of See Phil Masterson & Sue Wilchusky, Sizing Up the Current ETF Landscape, 2009 ETFS AND INDEXING 33, See id. at 37 n.5. Prior to that time, all ETFs were index-based ETFs, that is, they traced underlying indices. See id. 3. See id. 4. See id. at 34. Grail Advisors introduced the ETF. See id. 5. Jessica Toonkel & Suzanne Barlyn, Update 2-SEC Partially Lifts Moratorium on Actively Managed ETF, REUTERS.COM (Dec. 6, 2012, 6:50 PM), [hereinafter Moratorium]. 6. See James A. Bennett & Francis J. Kerins, Jr., Exchange Traded Funds: Liquidity & Informed Trading Levels, 2009 ETFS AND INDEXING 59 18, 18. Specifically, the industry grew from 100 ETFs and $100 billion [market] capitalization in June 2003 [to] 220 ETFs and $300 billion capitalization in February Id. 7. Id. 8. Jeff Cox, ETF Surge in 2012: They Are Here To Conquer, CNBC.COM (Dec. 28, 2012, 1:31 PM), Are_Here_to_Conquer See Masterson & Wilchusky, supra note 1, at 33.

3 Spring] Actively Managed ETFs: The Past, Present, and Future 233 ( Securities Act ), such as Commodity ETFs and exchange-traded notes (also known as ETNs). 10 Part II of this article provides some background information on the mechanics behind actively managed ETFs and the importance of arbitrage efficiency in the ETF market. Part III adds to this contextual background by discussing the regulatory framework surrounding actively managed ETFs. After providing the reader with this context, Part IV discusses the costs and benefits of actively managed ETFs, including distribution issues and the difficulty actively managed ETFs have in attracting assets. II. ETF MECHANICS AND ARBITRAGE EFFICIENCY ETFs are open-end investment companies that inexpensively combine properties of open-end mutual fund investment companies with those of closed-end investment companies. 11 Like mutual funds, ETFs can be purchased and redeemed directly, but unlike mutual funds, these purchases and redemptions can only take place in large blocks of shares called creation units. Like closed-end investment companies, individual ETF shares can be bought and sold on securities exchanges. Creations units, which generally consist of 25,000 to 50,000 individual shares, are bought and sold by or through an authorized participant. 12 In order to purchase a creation unit, an authorized participant must generally deliver a basket of underlying securities, known as the deposit securities, 10. See Testimony on Market Micro-Structure: An Examination of ETFs Before the Subcomm. on Sec., Ins., & Inv. of the S. Comm. on Banking, Hous.& Urban Affairs, 112th Cong. (2011) (testimony of Eileen Rominger, Director, Division of Investment Management, SEC) [hereinafter Rominger Testimony]. Exchange-traded notes are debt instruments issued by underwriting banks whose returns are linked to the performance of an underlying index. Id. 11. Bennett & Kerins, supra note 6, at 18. ETFs have characteristics of closed-end funds because shares must trade at negotiated prices on national securities exchanges. W. Thomas Conner, Evolution of Exchange Traded Products: How New SEC Rules May Tip the Competitive Balance, in Nuts and Bolts of Financial Products 300 (2009). Unlike closed-end funds which can trade at large discounts to NAV, ETFs tend to trade at small discounts or premiums, if any. Id. 12. An authorized participant must be either: (a) a broker-dealer or other participant in the continuous net settlement system of the National Securities Clearing Corporation, a clearing agency registered with the Commission, or (b) a participant in the Depository Trust Company. See Cambria Inv. Mgmt., L.P. & Cambria EFT Trust; Notice of Application, Investment Company Act Release No. 30,302, 77 Fed. Reg. 74,884 (proposed Dec. 12, 2012) [hereinafter Cambria]. See also Cambria Inv. Mgmt., L.P., Cambria EFT Trust, Investment Company Act Release No. 30,340, 2013 WL (Jan. 4, 2013). See William A. Birdthistle, The Fortune and Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds, 33 DEL J. CORP. L. 69, 78 (2008).

4 234 Journal of Business & Securities Law [Vol. 13 to the ETF. 13 In return, the ETF delivers a creation unit to the authorized participant, which the authorized participant breaks down and sells as individual shares to retail or institutional investors. Conversely, in order to redeem a creation unit, an authorized participant must acquire enough shares to form a creation unit, which is then delivered to the ETF 14 in return for a basket of securities, known as redemption securities, that generally corresponds pro rata to the deposit securities and to the entire portfolio of assets held by the ETF. 15 The functioning of the ETF market depends in large part on the ETFs ability to be efficiently arbitraged. Creating and redeeming ETFs only in creation unit sizes enables arbitrage opportunities for investors with enough resources to purchase or redeem such a large quantity of shares. One form of arbitrage in ETFs is known as riskless arbitrage and forms a small percentage of the transactions in ETF shares. 16 Trading firms and institutional investors engage in riskless arbitrage in ETFs by monitoring differences between the price of an ETF s shares traded on an exchange and the net asset value ( NAV ) of such ETF s creation units. If an ETF s shares are trading at a discount to NAV on the exchange, investors can purchase enough ETF shares to form a creation unit and then redeem the creation unit to make a profit. Conversely, if ETF shares are trading at a premium to NAV on an exchange, investors can purchase a creation unit and then sell shares to investors in order to make a profit Bennett & Kerins, supra note 6, at 19. The deposit securities are designated by the ETF. Id. 14. See id. 15. See Cambria, supra note 12, at 6. In some instances, ETFs may permit or require authorized participants to redeem creation units entirely in cash. Id. This flexibility is stated in the ETF s exemption application. One consequence of all cash redemptions is a lessening of such ETF s tax advantages because such ETF would not be distributing securities with the lowest cost basis to authorized participants. 16. See Letter from Ira P. Shapiro, Assoc. Gen. Counsel, Barclays Global Fund Advisors, to Nancy M. Morris, Sec y, SEC (May 16, 2008), [hereinafter BGFA Letter] (commenting on the Proposed ETF Rule (infra Part III F)). 17. It should be noted that an ETF would be prohibited from suspending redemptions under 15 U.S.C.A. 22(e) (1940), of the Investment Company Act of 1940, 15 U.S.C.A. 80a-51 (West 2012) (Pub. L. No (excluding Pub. L. Nos and )). However, there is no such prohibition for suspending creations. In September 2008, three ETFs, Rydex Investments 2X Inverse S&P Select Sector Financial ETF, Short Financials ProShares, and Ultrashort Financials ProShares, halted creations after the SEC temporarily banned short selling. See IndexUniverse, Rydex Follows ProShares in Suspending Creations of Financial Short ETF Shares, SEEKINGALPHA.COM (Sept. 24, 2008), available at See Oliver Ludwig, Creations Of Egypt ETF EGPT Suspended, INDEXUNIVERSE.COM (Jan. 31, 2011), Suspending creations would cause the arbitrage mechanism to break down because

5 Spring] Actively Managed ETFs: The Past, Present, and Future 235 More commonly, ETFs are arbitraged by the maintenance of a hedge position, adjusting it as necessary in response to sales and purchases of ETF shares. 18 This type of arbitrage is generally performed by professional trading firms, including authorized participants, which take either a long or short position in ETF shares. 19 The professional trading firms typically hedge their trading exposure to ETF shares by taking offsetting, correlated positions in derivative instruments, which are often considerably easier to trade quickly than the [deposit securities and redemption securities]. 20 The hedged position is then unwound by offsetting the derivative position and either delivering the ETF shares in return for redemption securities (if the hedged position is long) or delivering the deposit securities in return for ETF shares (if the hedged position is short). 21 The effect of this arbitrage process is to discipline the price of ETF shares so that they tend not to trade at significant discounts or premiums to NAV on the exchanges. 22 Arbitrage efficiency is critical to the ETF market because it provides for an efficient and orderly market whereby investors know that the price of an ETF share trading on an exchange is an accurate reflection of the NAV of the ETF s portfolio holdings. According to the SEC, ETFs offer advantages over closed-end funds because of this ability to greatly reduce discounts inherent in closed-end funds. 23 Arbitrage is described in each ETF order and the SEC has pointed out the benefits of arbitrage in the ETF market. 24 III. REGULATION OF ACTIVELY MANAGED ETFS Actively managed ETFs are extensively regulated under the Investment Company Act of They are also regulated under the Securities Act of 1933 ( Securities Act ) and the Securities Exchange Act arbitrageurs would no longer be able to purchase creation units when shares are trading at a premium to NAV. 18. BGFA Letter, supra note 16, at Id. 20. Id. at Id. at 6 n.14. In order for the arbitrage process to work efficiently, it is critical that ETF portfolios remain transparent. Otherwise, arbitrageurs would not be able to hedge their risk as effectively. 22. Bennett & Kerins, supra note 6, at 19. In contrast, shares of closed-end funds tend to trade at a discount to NAV because they cannot be redeemed. 23. Concept Release: Actively Managed Exchange Traded Funds, Investment Company Act Release No. 25,258, 66 Fed. Reg. 57,614 (proposed Nov. 15, 2001) [hereinafter Concept Release]. 24. See Concept Release, supra note Cambria, supra note 12; Rominger Testimony, supra note 10. See generally, How are ETFs regulated? Investment Company Institute s Frequently Asked Questions About Exchange-Traded Funds (ETFs),

6 236 Journal of Business & Securities Law [Vol. 13 of 1934 ( Exchange Act ). 26 The Securities Act regulates ETFs, including actively managed ETFs, similarly to the way it regulates other open-end investment companies. ETFs must register their shares for sale under the Securities Act and file a registration statement with the SEC. 27 However, regulation of ETFs under the Investment Company Act is different in comparison to other open-end investment companies. 28 A. Organization of ETFs Although the first ETFs were organized as unit investment trusts ( UITs ), most ETFs are now organized as open-end management investment companies. 29 ETFs that are UITs are organized under a trust agreement, have a trustee as opposed to a board of directors, and use passive, index-based investment strategies. 30 ETFs organized as open-end management investment companies have greater flexibility to pursue nonindex investing strategies. 31 For this reason, actively managed ETFs are organized as open-end management investment companies. B. Exemptions from the Investment Company Act ETFs must apply to the SEC for relief from various provisions of the Investment Company Act before selling shares to investors. In order to apply for exemptive relief, an applicant must first file an application on the SEC s Electronic Data Gathering, Analysis, and Retrieval ( EDGAR ) file management system. 32 The staff of the SEC s Office of Investment Company Regulation ( OICR ) first reviews the application to determine whether comments are necessary. OICR then issues any necessary comments on the application and requests that the applicant file an amendment to the application on EDGAR. The SEC staff issues the exemptive order, pursuant to delegated authority, after it is satisfied that the 26. Regulation under the Exchange Act is not discussed in this article. 27. Rominger Testimony, supra note Id. 29. The applicable statutory provisions regarding organization of an investment company are 4-5 of the Investment Company Act of See Investment Company Act of , 15 U.S.C.A. 80a-4-80a-5 (West 2012). 30. Paul J. McElroy, Exchange Traded Funds and Exchange Traded Notes, in NUTS AND BOLTS OF FINANCIAL PRODUCTS 341(2009). 31. Id. at 6-7. UITs are generally created for a specific length of time and have fixed portfolios. Thus, UITs securities generally will not be sold or new ones bought, which precludes active management. See id. at Filings & Forms, U.S. SECURITIES AND EXCHANGE COMMISSION, (Feb. 21, 2012).

7 Spring] Actively Managed ETFs: The Past, Present, and Future 237 necessary exemptive standards have been met and a notice has been issued. Typically, this is a lengthy process that takes more than a year. 33 Generally, ETFs require exemptive relief from five provisions of the Investment Company Act. First, ETF s issuance of shares in creation units, as opposed to traditional redeemable securities, requires exemptions from sections 2(a)(32) and 5(a)(1) of the Investment Company Act. 34 These exemptions allow an ETF to register as an open-end investment company 35 or a UIT. 36 Second, the redemption process requires exemptions from section 22(d) and rule 22(c)(1) because those provisions prohibit the selling of redeemable securities of a registered investment company in a public offering or from redeeming such securities at anything other than a price based on NAV. 37 These exemptions allow for the secondary trading of ETF shares negotiated at market prices rather than at NAV. Third, an ETF must also obtain an exemption from section 17(a), which generally prohibits an affiliated person of a registered investment company, or an affiliated person of such a person, from selling any security to or purchasing any security from the company. 38 The SEC grants exemptions to permit in-kind purchases and redemptions from persons who are affiliated with the ETF because they hold more than 5% of the voting securities or more than 25% of the outstanding ETF shares. 39 Fourth, an ETF may also receive an exemption from section 22(e). Such an exemption allows the ETF to pay redemption proceeds, under certain circumstances, more than seven days from the tender of shares for redemption. 40 This exemption is necessary given the different delivery cycles present in foreign markets. 41 Finally, many ETFs also receive exemptive orders from the SEC permitting unaffiliated investment companies (including unaffiliated ETFs) to purchase such ETFs shares beyond the limits set forth in sections 12(d)(1)(A) and (B). 42 Relying on these exemptive orders, unaffiliated 33. See id. Depending on the application, the SEC staff may provide more than one set of comments on an application. If the request for relief involves a novel issue requiring the approval of the Commission, the SEC staff might take more than a year to issue the order, if at all. Filing an ETF application that closely tracks the final application for the most recently granted ETF order may help decrease the time it takes to receive an ETF order. 34. See Concept Release, supra note See 15 U.S.C.A. 80a-5 (West 2010). 36. See id. 80a See id. 80a See id. 80a Cambria, supra note 12, at See id. at See 15 U.S.C.A. 80a-22 (West 2010). 42. See Cambria, supra note 12, at

8 238 Journal of Business & Securities Law [Vol. 13 investment companies can acquire the shares of such ETFs as long as they follow certain conditions, such as not controlling the ETFs. 43 C. ETF Index Tracking and Variations in Portfolio Disclosures All index-based ETFs must track an underlying index and disclose their deposit securities and balancing amounts each day in order to maintain transparency and allow investors to arbitrage discrepancies between the NAV per share of creation units and the price of shares traded on exchanges. 44 However, depending on the type of ETF, index tracking and portfolio disclosure can happen in different ways. Index-based ETFs, leveraged ETFs, and actively managed ETFs (as discussed later in the article) have different means of both index tracking and portfolio disclosure. Non-leveraged index-based ETFs must track underlying indices of either equity or fixed-income securities. 45 They do so through either replication or representative sampling strategies, as disclosed in their prospectuses. 46 Using a replication strategy, an index-based ETF will invest in all of the component securities of its underlying index in approximately the same proportions as found in the underlying index. Using a representative sampling strategy, an index-based ETF must invest at least 80% of its assets in the component securities of the underlying index. 47 The other 20% of the assets may be invested in a broad variety of other instruments, including securities not included in its underlying index, which the adviser or subadviser believes will assist the index-based ETF in tracking the performance of its underlying index. 48 Regarding portfolio disclosure, index-based ETFs must list the names and amount of each security constituting the current deposit securities and 43. See id. 44. See Foreside Advisor Serv., LLC; Notice of Application, Investment Company Act Release No. 30,284, 77 Fed. Reg. 72,416 (proposed Nov. 29, 2012) [hereinafter Foreside]. See also Foreside Advisor Serv., LLC, Investment Company Act Release No. 30,318, 2012 WL (Dec. 27, 2012). 45. See Foreside, supra note 44, at 4 n.2. To date, the SEC has not granted exemptive relief to permit an ETF that is registered as an investment company to track a commodities index. 46. See id. 47. See id. The percentage of an index-based ETF s assets that must be invested in the component securities of its underlying index varies depending on the terms of such ETF s exemptive order. Earlier exemptive orders stated that 90% of the ETF s assets must be invested in the underlying index components. The SEC staff has issued a no-action letter permitting an ETF to track indices by investing in other ETFs. See, e.g., ishares Trust ishares, Inc., Investment Company Act Release No. 29,571, 100 SEC Docket 1110 (Jan. 24, 2011). Other ETFs track indices by investing in a portfolio of ETFs as stated in their exemptive applications. See, e.g., IndexIQ ETF Trust; Notice of Application, Investment Company Act Release No. 28,638, 95 SEC Docket 951 (Feb. 27, 2009). 48. See Foreside, supra note 44, at 4.

9 Spring] Actively Managed ETFs: The Past, Present, and Future 239 the balancing amount 49 on each business day prior to the opening of trading on the primary listing exchange. Any exchange on which such index-based ETF s shares are listed will disseminate, every 15 seconds during its regular trading hours, an amount per share representing the sum of the estimated balancing amount and the current value of the deposit securities. 50 Also, the value of an index-based ETF s underlying index is generally disseminated every 15 seconds throughout the trading day. 51 Leveraged ETFs seek to track the inverse, multiple, or inverse multiple of an underlying index on a daily basis. 52 Leveraged ETFs use replication or representative sampling strategies in seeking investment results. 53 They also use money market instruments, futures, options, equity caps, collars and floors, swap agreements, forward contracts, and repossessions to meet their investment objectives. 54 Regarding portfolio disclosure, leveraged ETFs, on each business day, disclose their full portfolio holdings on their websites, the exchange on which their shares are listed, or both. The portfolio holdings information disclosed each business day forms the basis for such leveraged ETFs NAV calculation and reflects portfolio trades made on the immediately preceding business day. Intra-day values of each underlying index are disseminated every 15 seconds throughout the trading day. The value of underlying fixed income indices are calculated and published once per day See id. at 7. The difference between the NAV of a creation unit and the market value of the deposit securities of a creation unit is known as the cash amount. See id. at See Foreside, supra note 44, at See id. at See Rafferty Asset Mgmt., LLC; Notice of Application, Investment Company Act Release No. 28,379, 94 SEC Docket 316 (Sept. 12, 2008) [hereinafter Rafferty]. See also Rafferty Asset Mgmt., LLC, Investment Company Act Release No. 28,434, 2008 WL (Oct. 6, 2008). For example, the ProShares UltraShort Dow30 ETF seeks daily investment results equal to 200% of the inverse of the Dow Jones Industrial Average on a daily basis and the Direxion Daily Large Cap Bull 3X Shares ETF seeks daily investment results equal to 300% of the Russell 1000 index on a daily basis. See UltraShort Dow30, PROSHARES (Mar. 31, 2013), see also Direxion Daily S&P 500 Bull 3x Shares, DIREXION (Mar. 31, 2013), Although leveraged ETFs are generally successful at achieving the intended results on a daily basis, the same is not true over periods longer than a day. Therefore, leveraged ETFs are not appropriate investments for buy and hold investors. Investors have filed several lawsuits against leveraged ETFs arguing that the risks of holding such investments for more than a day were not adequately disclosed. See Daisy Maxey, ProShare Draws Suit Over a Leveraged ETF, WALL ST. J., (Aug. 7, 2009), available at see also Michael Johnston, The Crusade Continues: More Laughable Leveraged ETF Lawsuits, SEEKINGALPHA.COM (Jan. 22, 2010), available at Rafferty, supra note 52, at Id.

10 240 Journal of Business & Securities Law [Vol. 13 D. The Actively Managed Exchange Traded Fund Concept Release In 2001, the SEC issued a concept release ( Concept Release ) to seek comment regarding actively managed ETF issues. 56 The Concept Release set forth various concerns related to actively managed ETFs. First, the SEC questioned whether the Commission should allow actively managed ETFs to be less transparent than index-based ETFs because their portfolios likely would change more often and in less foreseeable ways than the portfolios of index-based ETFs. 57 Second, the SEC questioned whether full transparency of an actively managed ETF s holdings would allow investors to guess the trading strategy and trade ahead of the actively managed ETF and creation unit purchasers. 58 Third, the SEC questioned whether actively managed ETFs should be limited to certain investment objectives or policies that are designed to ensure that the portfolio securities are sufficiently liquid to permit effective arbitrage. 59 Fourth, the SEC expressed concern over the potential for an actively managed ETF s adviser to designate securities in the creation or redemption basket that would favor an affiliate. 60 The SEC noted that an index-based ETF would be less likely to favor an affiliate because index-based ETFs are limited to investing in securities that fit within the composition of the underlying index. 61 E. Actively Managed ETF Exemptive Orders In February 2008, the SEC issued the first exemptive orders permitting an ETF to pursue active management strategies. 62 Although the orders included similar terms and conditions as previous ETF orders, there were a few differences that have been included in all subsequent actively 56. See Concept Release, supra note See id. at See id. at 9. Trading ahead of an actively managed ETF would bid up the price of the securities targeted by the actively managed ETF. 59. See id. at See id. at See id. at See, e.g., PowerShares Capital Mgmt., LLC; Notice of Application, Investment Company Act Release No. 28,140, 92 SEC Docket 1648 (Feb ); Bear Stearns Asset Mgmt., Inc; Notice of Application, Investment Company Act Release No. 28,143, 92 SEC Docket 1659 (Feb. 5, 2008); Barclays Global Fund Advisors; Notice of Application Investment Company Act Release No , 92 SEC Docket 1668 (Feb. 6, 2008); WisdomTree Trust; Notice of Application, Investment Company Act Release No , 92 SEC Docket 1672 (Feb. 6, 2008). See also PowerShares Capital Mgmt., LLC, Investment Company Act Release No. 28,171, 2008 WL (Feb. 27, 2008); Bear Stearns Asset Mgmt., Inc., Investment Company Act Release No. 28,172, 2008 WL (Feb. 27, 2008); Barclays Global Fund Advisors, Investment Company Act Release No. 28,173, 2008 WL (Feb. 27, 2008); WisdomTree Trust, Investment Company Act Release No. 28,174, 2008 WL (Feb. 27, 2008) [hereinafter First Active ETF Orders].

11 Spring] Actively Managed ETFs: The Past, Present, and Future 241 managed ETF orders including daily portfolio disclosure of all portfolio instruments, sales and marketing disclosures, and a statement related to section 48(a) of the Investment Company Act Daily Full Portfolio Disclosure On each business day, actively managed ETFs must disclose on their websites the identities and quantities of the portfolio instruments and other assets they hold that will form the basis for their calculation of NAV at the end of the day. 64 It is interesting to note that trades made during the day by an actively managed ETF (or any investment company for that matter) are not reflected in that day s NAV. Rather, they are reflected in the next day s NAV. Thus, any trading during the day by an actively managed ETF would not decrease the transparency of such ETF nor would it affect an arbitrageur s ability to effectively arbitrage the ETF. In contrast, an index-based ETF is not required to disclose the identities and quantities of all of its assets each morning. 65 Rather, it must disclose the identities of the deposit securities used to purchase a creation unit each morning. 66 Until 2010, index-based ETFs represented in their exemptive applications that such lists would generally correspond pro rata to the portfolio holdings of the ETF. 67 However, beginning in 2010, indexbased ETF orders included representations that: The Deposit Securities and Redemption Securities may differ from each other (and from the portfolio [holdings]) (a) to reflect minor differences when it is not possible to break up bonds beyond certain minimum sizes needed for transfer and settlement, or (b) for temporary periods to effect changes in the [p]ortfolio [holdings] as a result of the rebalancing of an Underlying Index First Active ETF Orders, supra note See e.g., Cambria, supra note 12, at 21; See ICI FACT BOOK, infra note 65, at chap. 3. In addition, every fifteen seconds throughout the trading day, the exchange on which an actively managed ETF is listed must disclose the sum of the current value of the portfolio instruments held by the actively managed ETF. 65. See INVESTMENT COMPANY INSTITUTE, INVESTMENT COMPANY FACT BOOK 46 (52nd ed. 2012) ( Actively managed ETFs and certain types of index-based ETFs are required to publish their complete portfolio holdings in addition to their creation basket. ) [hereinafter ICI FACT BOOK], available at See Foreside, supra note 44, at See ShariahShares Exchange-Traded Fund Trust; Notice of Application, Investment Company Act Release No. 29,127, 97 SEC Docket 2594 (Jan. 29, 2010) [hereinafter ShariahShares] (stating some of the exceptions to the deposit securities corresponding pro rata to the portfolio of the ETF include instances where a security may not be readily available, where the investment adviser needs assistance in rebalancing the ETF s portfolio or as a result of corporate actions). 68. ETSpreads, LLC; Notice of Application, Investment Company Act Release No. 29,501, 99 SEC Docket 2909 (Nov. 18, 2010) at 4 n.11; see also ETSpreads, LLC,

12 242 Journal of Business & Securities Law [Vol. 13 Therefore, an argument can be made that actively managed ETFs are more transparent than index-based ETFs (relying on exemptive orders issued prior to 2010) because actively managed ETFs full portfolio holdings are disclosed instead of a general pro rata representation of portfolio holdings with exceptions. 2. Sales and Marketing Disclosures As conditions to their exemptive orders, both actively managed and index-based ETFs must prominently disclose in their prospectuses and marketing materials that their shares are redeemable only in creation units and are not individually redeemable. Actively managed ETFs must also prominently disclose in their prospectuses and advertising materials that they are actively managed exchange-traded funds or actively managed ETFs. 3. Section 48(a) Statement An actively managed ETF, as a condition to its exemptive order, must state that its advisor or any subadvisor, directly or indirectly, will not cause any authorized participant (or any investor on whose behalf an authorized participant may transact with the ETF) to acquire any deposit security for the ETF through a transaction in which the ETF could not engage directly. 69 The purpose of this statement is to reiterate that an actively managed ETF advisor must comply with section 48(a) of the Investment Company Act, which prohibits an investment company from doing indirectly what it is not allowed to do directly. 70 Investment Company Act Release No. 29,525, 2010 WL (Dec. 14, 2010). The most recent ETF orders have included representations with more specific exceptions such as: the Deposit Instruments and the Redemption Instruments will each correspond pro rata to the positions in a Fund s portfolio (including cash positions), except: (a) in the case of bonds, for minor differences when it is impossible to break up bonds beyond certain minimum sizes needed for transfer and settlement; (b) for minor differences when rounding is necessary to eliminate fractional shares or lots that are not tradeable round lots; (c) to be announced transactions ( TBA Transactions ), derivatives and other positions that cannot be transferred in kind will be excluded from the Deposit Instruments and the Redemption Instruments; (d) to the extent the Fund determines, on a given Business Day, to use a representative sampling of the Fund s portfolio; or (e) for temporary periods, to effect changes in the Fund s portfolio as a result of the rebalancing of its Underlying Index. See Foreside, supra note 44, at See Cambria, supra note 12, at U.S.C.A. 80a-48 (West 2010).

13 Spring] Actively Managed ETFs: The Past, Present, and Future ETF Rule An actively managed ETF, as a condition to its exemptive order, must state that its 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. 71 This could have implications for actively managed ETFs, as discussed below, depending on the final form of the Proposed ETF Rule, should such a rule be adopted. F. The Proposed ETF Rule In 2008, the SEC proposed a new rule that would generally eliminate the need for certain ETFs to seek exemptive relief under Section 6(c) of the Investment Company Act ( Proposed ETF Rule ). 72 Although comments on the proposal were due by May 19, 2008, the SEC has not passed a final rule as of January The proposed rule, if adopted, would automatically grant exemptions from several sections of the Investment Company Act. 74 The following discussion highlights some of these automatic exemptions. First, it would deem ETF shares to be redeemable securities under Section 2(a)(32). 75 Second, it would allow the purchase and sale of ETF shares in the secondary market by codifying an exemption from Section 22(d) and Rule 22c Third, it would allow certain affiliated persons to participate in in-kind creations and redemptions of ETFs. 77 This exemptive relief would extend to affiliated persons who hold 5% or more of the voting stock of either the ETF or an investment company controlled by the ETF. 78 All of these provisions would apply to an open-end investment company (but not those organized as UITs) that meets the proposed definition of exchange-traded fund. 79 Fourth, it would amend prior exemptive orders to 71. See Cambria, supra note 12, at Exchange-Traded Funds, 73 Fed. Reg. 14,618 (proposed Mar. 11, 2008) (to be codified at 17 C.F.R pts. 239, 270, 274) [hereinafter Proposed ETF Rule]; Conner, supra note 11, at See Ari I. Weinberg, The Lawless Society of ETFs, FORBES, Oct. 9, 2012, (noting comments by David Mann that the last activity on this proposed rule was in November 2009). 74. See id. 75. Conner, supra note 11, at Id. 77. Id. at Id. at See id. The Proposed ETF Rule s definition of exchange-traded fund is a registered open-end management company that: (i) [i]ssues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated on a per share basis by a national securities exchange at reg-

14 244 Journal of Business & Securities Law [Vol. 13 eliminate the section 24(d) exemption, which permits broker-dealers to deliver a product description instead of a prospectus in connection with secondary market sales of certain ETFs. 80 The Proposed ETF Rule would eliminate this exemption because, in practice, broker-dealers are not relying on the relief. Instead, they are delivering prospectuses in connection with every ETF sale in the secondary market. 81 The Proposed ETF rule, if adopted, would affect actively managed ETFs in several ways. First, it would permit them (in addition to leveraged and index-based ETFs) to operate without having to seek exemptive relief under the Investment Company Act. 82 Second, the Proposed ETF Rule would require any ETF to either disclose its full portfolio each business day or track an underlying index that discloses its component securities. 83 Since actively managed ETFs do not track indices, they would have to disclose their portfolio on a daily basis. 84 However, the Proposed ETF rule does not specify at what time during the day the ETF must disclose its portfolio nor does it specify that it must disclose all assets that will form the basis for that day s NAV. 85 Third, the Proposed ETF rule does not require that the deposit securities and redemption securities mirror the portfolio of the ETF. 86 Thus, under the Proposed ETF rule, it is unclear whether an actively managed ETF would be as transparent as is currently required under SEC exemptive orders. ular intervals during the trading day; (ii) [i]n any sales literature, identifies itself as an exchange-traded fund, which does not sell or redeem individual shares, and explains that investors may purchase or sell individual exchange-traded fund shares on a national securities exchange; (iii) [i]ssues shares that are approved for listing and trading on a national securities exchange under section 12(d) (15 U.S.C. 78l(d)) of the Securities Exchange Act of 1934 and rule 12d1-1 (17 C.F.R d1-1) thereunder; (iv) [d]iscloses each business day on its Internet Web site, which is publicly accessible at no charge, the prior business day s net asset value and closing market price of the fund s shares, and the premium or discount of the closing market price against the net asset value of the fund s shares as a percentage of net asset value; and (v) [e]ither: (A) [d]iscloses each business day on its Internet Web site, which is publicly accessible at no charge, the identities and weightings of the component securities and other assets held by the fund, or (B) [h]as a stated investment objective of obtaining returns that correspond to the returns of a securities index specified in the fund s registration statement, and the index provider discloses on its Internet Web site, which is publicly accessible at no charge, the identities and weightings of the component securities and other assets of the index. Proposed ETF Rule, supra note 72, at Proposed ETF Rule, supra note 72, at Also, a summary prospectus may be delivered instead of a full statutory prospectus. See infra note Proposed ETF Rule, supra note See id. at See id. 85. Id. at Id. at 15.

15 Spring] Actively Managed ETFs: The Past, Present, and Future 245 The SEC also posed a couple of questions in the Proposed ETF Rule. First, the SEC questioned whether the Proposed ETF Rule should apply only to index-based ETFs. 87 Second, the SEC questioned whether the section 24(d) exemption to permit the delivery of a product description instead of a prospectus should apply to actively managed ETFs. 88 The Proposed ETF Rule suggests that actively managed ETFs have more complex investment objectives and techniques and should, therefore, be required to deliver a full prospectus instead of a product description. 89 As discussed below, all ETFs may now deliver a summary prospectus instead of a full prospectus. 90 G. Disclosure Issues and Amended Form N-1A The Investment Company Act prohibits any investment company that declares itself diversified from investing more than 5% of its total assets in any single issuer, with respect to 75% of its total assets. 91 Further, an investment company that is concentrated in a particular industry must invest at least 25% of its assets in that industry. 92 These requirements limit the investment strategies of ETFs. 93 Additionally, as discussed above, all openend investment companies, including actively managed ETFs, must have a minimum of 85% of their total assets invested in liquid securities. 94 This requirement further restricts ETFs investment strategies. These restrictions are particularly difficult for niche ETFs that invest in less liquid portions of the global market. The SEC adopted a rule in March 2009 that requires enhanced disclosure on form N-1A and enables a new prospectus delivery option for registered open-end management investment companies ( Summary Prospectus Rule ). 95 The Summary Prospectus Rule permits a person selling an open-end ETF (or any other open-end investment company) to satisfy its 87. See id. at See id. 89. See id. 90. See Enhanced Disclosure and New Prospectus Delivery Option For Registered Open-End Management Investment Companies, 17 C.F.R. 230, 232, 239, 274 [hereinafter Summary Prospectus Rule]. 91. See Investment Company Act of 1940, 15 U.S.C.A. 80a (West 2012) (Pub. L. No (excluding Pub. L. Nos and )). 92. See 26 U.S.C.A. 851 (West 2010). 93. A recent analysis of 2008 tracking errors suggested that newer, more highly optimized ETFs suffered from greater tracking error due in large part to higher expenses and diversification requirements under the Investment Company Act. See Proposed ETF Rule, supra note 72, at See Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18,612, 50 SEC Docket 1659 (Mar. 12, 1992). 95. See generally Summary Prospectus Rule, supra note 90.

16 246 Journal of Business & Securities Law [Vol. 13 prospectus delivery obligations by sending a summary prospectus rather than a statutory prospectus as long as the full prospectus is available on the ETF s website. 96 Thus, it is possible that a final ETF Rule may not require delivery of the product description due to liability issues that have resulted in an industry practice of full disclosure. 97 These liability issues, however, were not discussed in the Proposed ETF Rule. The Summary Prospectus Rule also changes some of the disclosure requirements for ETFs, including eliminating disclosure about creations and redemptions and requiring the disclosure of information about premiums and discounts to NAV. 98 Of particular interest to actively managed ETFs, the Summary Prospectus Rule requires investment companies to disclose information about their fee tables and their portfolio managers in the summary prospectus. 99 A portfolio manager s length of service for an investment company must be disclosed, as well as a statement that information about the portfolio manager s compensation can be found in the statement of additional information. 100 H. Use of Derivatives by Actively Managed ETFs In 2010, the Commission issued a press release stating that its staff was conducting a review to evaluate the use of derivatives by mutual funds, ETFs and other investment companies ( Derivatives Press Release ). 101 The press release stated that the staff would defer review of exemptive applications for ETFs that make significant use of derivatives. 102 After the 96. See id. at A person selling an ETF organized as an UIT is not permitted under the Summary Prospectus Rule to deliver a summary prospectus in lieu of a full prospectus because a UIT is not a management investment company. See id. at See Conner, supra note 11, at See Summary Prospectus Rule, supra note 90, at Disclosure about creations and redemptions was eliminated because retail investors do not need such information since they purchase and sell ETF shares on exchanges. Id. at See id. at 32, See id. at See Press Release, SEC, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 2010), [hereinafter Derivatives Press Release]; see also Letter from Barry D. Miller, Assoc. Dir., Office of Legal and Disclosure, to Karrie McMillan, Gen. Counsel, Inv. Co. Inst. at 2 (July 30, 2010), (explaining that the Commission staff s primary observation concerning the derivatives review is that some funds provide generic disclosures about derivatives that may be of limited usefulness for investors in evaluating the anticipated investment operations of the fund, including how the fund s investment adviser actually intends to manage the fund s portfolio and the consequent risks. ) The Derivatives Press Release gives several reasons for this new staff position including to explore whether: (1) the use of derivatives is consistent with the leverage, concentration, and diversification provisions of the Act; (2) board oversight and risk

17 Spring] Actively Managed ETFs: The Past, Present, and Future 247 Derivatives Press Release was issued, all actively managed ETF exemptive orders were required to include a representation that the ETFs relying on such orders would not invest in options contracts, futures contracts, or swap agreements. 103 Index based ETF orders issued after the Derivatives Press Release included relief permitting such ETFs to invest up to 20% of their assets in certain futures, stock options, options on stock index futures, and swap contracts as related to their respective underlying index, as well as in stocks not included in its underlying index, but which the adviser believes would help the ETF track its underlying index. 104 The Commission s moratorium on granting exemptive relief to permit actively managed and leveraged ETFs to use derivatives did not apply to actively managed and leveraged ETFs that had already been granted ETF orders. 105 As a result, any ETF with an existing actively managed ETF or leveraged ETF order was at a competitive advantage compared to ETFs that had not received such orders. 106 On December 6, 2012, the SEC staff announced that they would lift the moratorium on granting exemptive orders to ETFs that permit the use of derivatives. 107 In a speech given on the same day, Norm Champ, Director of the Division of Investment Management of the SEC, announced that actively managed ETFs would have to comply with the following two conditions in order to invest in derivatives: (i) that the ETF s board periodically will review and approve the ETF s use of derivatives and how the ETF s investment adviser assesses and manages risk with respect to the ETF s use of derivatives; and (ii) that the ETF s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant Commission and staff guidance. 108 Any ETF relying on an exemptive order issued during the moratorium may invest in derivatives in reliance on the December 6, 2012 staff letter. 109 management procedures regarding derivatives are adequate; (3) existing rules sufficiently address a fund s pricing and liquidity determinations regarding its derivatives holdings are appropriate; (4) existing prospectus disclosures adequately address the particular risks created by derivatives. Derivatives Press Release, supra note See id See ShariahShares, supra note 67, at 4. This exception only pertains to the 20% asset basket. Id. at 4 n See Derivatives Press Release, supra note Recently, Russell Investments purchased U.S. One. U.S. One s exemptive order does not prohibit investments in derivatives See Letter from Elizabeth G. Osterman, Assoc. Dir., SEC (Dec. 6, 2012), available at etf.pdf See Remarks of Norm Champ to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services, Dec. 6, 2012, available at See supra note 101.

18 248 Journal of Business & Securities Law [Vol. 13 (i) the ETF s board periodically will review and approve the ETF s use of derivatives and how the ETF s investment adviser assesses and manages risk with respect to the ETF s use of derivatives; and (ii) the ETF s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant SEC and staff guidance.(i) the ETF s board periodically will review and approve the ETF s use of derivatives and how the ETF s investment adviser assesses and manages risk with respect to the ETF s use of derivatives; and (ii) the ETF s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant SEC and staff guidance. I. Fully Transparent Versus Non-Transparent Actively Managed ETFs All current actively managed ETFs are considered fully transparent because they disclose their full portfolio holdings each day. 110 In contrast, over the last several years, three companies have filed exemptive applications to permit non-transparent actively managed ETFs. 111 Nontransparent actively managed ETFs would seek to facilitate the arbitrage mechanism in ways other than through full portfolio disclosure. To date, the SEC has not granted any exemptive order to permit a nontransparent actively managed ETF. 112 Andrew Donohue, the former Director of the Division of Investment Management at the SEC, speaking of nontransparent actively managed ETFs, stated, I m concerned that the lack of transparency will disrupt the process that keeps a fund s per-share net asset value and share price closely aligned. 113 Any non-transparent, actively managed ETF would likely have to overcome this concern in order to receive exemptive relief ICI FACT BOOK, supra note See Oliver Ludwig, BlackRock Plans Non-Transparent Active ETFs, INDEX UNIVERSE (Sept. 1, 2011), Daisey Maxey, A More Active Role, WALL ST. J. (July 6, 2009), html; Managed ETFs LLC, Edgar File No (Aug. 29, 2005), available at index.htm See generally, Cailyn Grudzinski, As ETFs Evolve, New Species Emerge, THE STREET (August 2, 2012), (noting that the regulators failure to approve a nontransparent ETF structure is restricting development of actively managed ETFs) Christopher Condon, BlackRock Faces SEC Hurdle With ETFs Seeking Secrecy to Rival Mutual Funds, BLOOMBERG.COM (June 24, 2010, 12:01 AM),

19 Spring] Actively Managed ETFs: The Past, Present, and Future 249 IV. LOOKING AHEAD: THE FUTURE OF ACTIVELY MANAGED ETFS The SEC approved the first actively managed ETF application in February In five years, the number of actively managed ETF orders has increased to 37. However, the number of actively managed ETFs comprises less than 1% of the entire ETF market. 115 As more investors shift from mutual funds to ETFs or include ETFs in their portfolio, it is likely that more fund managers will focus on actively managed ETFs. Similarly, experienced, actively managed mutual fund managers may start leaving that industry for the ETF industry, bringing both experience and clients. Fund managers are seeking newer, more innovative products in order to capture market share and increase their fees by increasing their assets under management. Additionally, investors looking to beat a particular benchmark will seek an investment vehicle that can, in theory, outsmart the market. Thus, actively managed ETFs are intended to both increase ETF market share and greatly expand... the possible range of investment strategies for funds. 116 This expansion, however, will only occur if investors believe that the costs outweigh the benefits of actively managed ETFs. A. Costs and Benefits of Actively Managed ETFs ETFs, including actively managed ETFs, provide liquidity, efficiency, and tax advantages while protecting investors from the problems affecting mutual funds. 117 Accordingly, numerous scandals regarding mutual funds over the past decade have channeled investors away from the once dominant mutual fund to the more novel ETF. 118 Generally, actively managed ETFs contrast with index-based ETFs and actively managed mutual funds in the following areas: (1) transparency, (2) liquidity, (3) tax efficiency, (4) transaction and operating costs, (5) management fees, and (6) spreads Transparency and Liquidity As discussed below, there are four primary factors that contribute to ETFs transparency and liquidity. First, index-based ETFs have passive 114. See First Active ETF Orders, supra note Moratorium, supra note Birdthistle, supra note 12, at 82. Currently, the number of actively managed ETFs is approximately 500 compared to over 8,000 actively managed mutual funds. Id. at See id. at Id. at 73. These scandals include market timing, late trading, front running, [and] unfair valuation. Id See Bennett & Kerins, supra note 6, at 18. See also Proposed ETF Rule, supra note 72 (for other characteristics that have made ETFs attractive to investors).

20 250 Journal of Business & Securities Law [Vol. 13 portfolios that track indexes that disclose their underlying components, which allows for easy calculation of such ETF s NAV at any given time. 120 Second, actively managed and leveraged ETFs disclose their full portfolio holdings on a daily basis. 121 Third, ETFs disclose their creation and redemption lists daily. Fourth, ETF shares are subject to intraday trading on exchanges and are continually purchased and redeemed in creation unit sizes. 122 Intraday pricing of ETF shares on exchanges allows ETFs to immediately reflect changes in the market. This intraday transparency contrasts with the mutual fund industry in which share prices are only available after the close of each business day. 123 Intraday valuation of ETFs assets can be difficult if they are less liquid, while liquid assets, such as those quoted on exchanges, are easily valued. Thus, although intraday transparency may benefit arbitrageurs by making market information easily digestible, it is premised on the ability to get readily obtainable values for ETFs portfolio holdings. A study by Professors James A. Bennett and Francis J. Kerins, Jr. suggests that actively managed ETFs may be more suited for sophisticated investors, 124 or conversely, may not be suited for less sophisticated investors. 125 Their study sought to demonstrate two points. First, ETFs should be more liquid than the funds underlying securities. 126 They defined liquidity as lower spreads and higher depths. 127 Professors Bennett and Kerins results supported the conclusion that ETFs offer greater liquidity than individual equities. 128 Second, the ETFs should feature lower levels of informed trading, which, in turn, implies that the adverse selection component of the bid-ask spread should be lower for ETFs than for other securities. 129 Again, Professors Bennett and Kerins found that their results supported the conclusion that ETFs feature significantly lower levels of informed trading relative to individual equities. 130 ETFs built-in arbitrage mechanism is also a component of their liquidity. The use of in-kind creations and redemptions results in the creation of parallel currencies between ETF shares and the basket of 120. Bennett & Kerins, supra note 6, at Masterson & Wilchusky, supra note 1, at Id See Birdthistle, supra note 12, at See generally, Bennett & Kerins, supra note See id. at Id. at See id. at 20. A security with higher depth would not be significantly affected by a large order Id. at Id. at Id. at 28.