(Article from Registered Funds Alert, February 2015)
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In the past few months, there has been a flurry of SEC activity in the non-transparent actively managed exchange-traded fund (ETF) space. As the ETF industry continues to grow at a blistering pace, with global assets under management recently eclipsing the $2.5 trillion mark, actively managed ETFs present a new opportunity for asset managers to grow market share. Traditionally, the advantage of offering ETFs as opposed to mutual funds has been in tax efficiencies and externalization of trading costs to the fund. Even where those advantages are blunted (for example, because creation units are purchased and redeemed in cash instead of in-kind), ETFs are attractive to certain investors who wish to use their existing brokerage accounts or who prefer intraday pricing. The ETF channel is, therefore, an attractive distribution channel for many fund sponsors at a minimum.
However, actively managed ETFs currently represent less than one percent of total ETF assets under management in the U.S., partially as a result of the SEC requirement of daily portfolio disclosure. While the benefits of actively managed ETFs seem clear, thus far fund transparency requirements have stunted the growth of this market. In the past quarter, there have been significant developments relating to these transparency requirements.
Non-Transparent Active ETF Proposals
Under current exemptions granted to sponsors of ETFs, actively managed ETFs are required each day to publish their entire portfolio holdings to the public. Traditional mutual funds, on the other hand, are only required to disclose their portfolio holdings on a quarterly basis, and even then on a delayed basis. From a sponsor’s point of view, a major drawback of portfolio transparency is that it allows potential front-runners to anticipate an ETF’s positions by buying or shorting the securities that the ETF is looking to purchase or sell. Moreover, the daily disclosure requirements make it difficult for fund managers to disguise their investment tactics and strategies more generally.
In a bid to limit SEC disclosure requirements, several sponsors have submitted proposals to the SEC requesting exemptions that would permit less transparency. The BlackRock and Precidian proposals utilize a blind-trust mechanism placed between the ETF and the authorized participant, which acts as a screen preventing the public, and the authorized participant, from viewing the fund’s underlying assets. T. Rowe Price’s proposal advocates for replacing full-portfolio disclosure with partial disclosure of a daily hedge portfolio in which each fund invests at least 80% of its total assets, acting as a type of proxy basket. In addition, investors would be provided data points detailing the differences between the actual portfolio and the hedge portfolio to narrow the differential between the proxy and actual baskets.
Lastly, Eaton Vance’s proposal advances a novel mutual fund-ETF hybrid called an exchange traded mutual fund (ETMF). ETMFs possess characteristics of both ETFs and mutual funds. Like ETFs, ETMFs would issue and redeem large chunks of shares known as “creation baskets” to and from authorized participants primarily via in-kind transfers composed of the fund portfolio’s underlying securities. The authorized participants would then trade the shares on a national security exchange where retail investors can purchase the shares in smaller quantities.
Perhaps most important to Eaton Vance, portfolio disclosure would only be required on a quarterly basis. In order to protect the confidentiality of the fund’s holdings, ETMF advisers would decide which underlying securities to include in the creation baskets issued to authorized participants with the balance paid in cash. This allows ETMFs to disguise the implementation of their investment strategy and make predatory front running a more difficult endeavor.
The pricing mechanism for ETMFs is novel. Shares would trade throughout the day on exchanges at prices quoted relative to NAV (plus or minus a premium or discount decided by market makers); however, the final transaction price would not be locked in until the end of the day when the NAV is calculated. The result is that investors would know the premium or discount at the time of each trade, but like intraday orders to buy or sell shares of mutual funds, an ETMF investor would not know the NAV (and thereby the final price per share) at the time the order is placed. The amount of the premium/discount would depend on a myriad of market factors, including the balance of supply and demand for shares among investors, the transaction fees and other costs associated with creating and redeeming creation units, competition among market makers, share inventory positions, inventory strategies of market makers and the volume of share trading.
Eaton Vance’s proposal allows ETMFs to benefit from the tax efficiencies and cost savings of an ETF, accomplished through in-kind transfers that pass on a portion of the costs to authorized participants, plus the more limited quarterly transparency requirements of a traditional mutual fund.
The SEC Responds
Almost two weeks after the SEC published notices (click here and here for links to the notices) stating its intent to deny exemptive relief requests sought by BlackRock and Precidian, the SEC published a notice of intention on November 6, 2014 giving preliminary approval to Eaton Vance’s ETMF request. The SEC has not yet commented on T. Rowe Price’s proposal, the last amendment to which was submitted in
March 2014.
SEC is Critical of BlackRock and Precidian Proposals
ETFs are permitted to function pursuant to SEC exemptive relief from various provisions of the 1940 Act. A hallmark of these exemptions is the SEC’s expectation that ETF shares trade at a price that is as close as possible to the NAV per share of the ETF. Historically, the SEC has viewed daily portfolio transparency as one key mechanism that ensures that market prices of ETF shares are close to the NAV. The theory is that transparency provides authorized participants sufficient information to implement an effective arbitrage strategy.
In their applications, BlackRock and Precidian propose several novel mechanisms that would enable them to operate on a less transparent basis while at the same time purportedly preserving market makers’ ability to capitalize on arbitrage opportunities in the market:
- The funds would be required to disclose portfolio holdings on a quarterly basis instead of on a daily basis similar to traditional mutual funds.
- Authorized participants would have access to an intraday indicative value (IIV) disseminated by exchanges every 15 seconds during the trading day, based on the last available market quotation or sale price of the ETF’s portfolio holdings. However, the applicants concede that the IIV is not a real-time NAV for the ETF and would not include extraordinary expenses or liabilities booked during the day.
- Blind trusts would be established whereby authorized participants could purchase or redeem creation baskets by paying cash to the trusts which would then transact with the ETFs via in-kind transfers of the fund’s securities without revealing the identity of the ETF’s underlying portfolio contents to authorized participants or the general public.
- Retail investors would be able to redeem individual shares directly from the ETFs in the event of a persistent and significant deviation of closing market price from the NAV, subject to a redemption fee of up to 2% and additional brokerage commissions.
The SEC disagreed with the assertion by Blackrock and Precidian that the proposed mechanisms would keep the market share price close to the NAV. Specifically, the SEC stated: “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.” The SEC release also casts doubt on the use of IIV or blind trusts as alternative mechanisms to ensure appropriate arbitrage opportunities, a key factor in previous SEC exemptions.
The SEC stated that the use of IIV in place of real-time data could result in inaccurate calculations of share price, particularly in times of market stress or volatility. The SEC was unconvinced that IIV would serve as a good substitute for the transparency of a fund’s underlying holdings—a necessary component to provide information to enable effective arbitrage by market makers. The SEC noted that in the case of transparent ETFs, market makers calculate their own NAV using proprietary algorithms based on the ETFs’ actual holdings and they only use IIV as a secondary or tertiary indicator of ETF share value. If market makers can no longer calculate their own NAV based on the value of an ETF’s underlying assets, then arbitrage opportunities will be limited, causing market makers to hesitate to trade under such conditions. The SEC also voiced concern that because there are no uniform methodology requirements in calculating the IIV, it could result in potentially arbitrary and inconsistent valuations.
Additionally, the release highlighted the SEC’s concern that quarterly disclosure of portfolio holdings would be insufficient and quickly lose relevance as ETF’s holdings could change daily (although it is not clear why that is more true for ETFs than other products that disclose holdings quarterly). Finally, the SEC was not convinced that the proposed back-up mechanism would be utilized by retail investors or provide an effective backstop to authorized participant arbitrage.
SEC Approves ETMF Structure
On the other hand, on December 2, 2014 the SEC issued an order approving the proposal advanced by Eaton Vance, after initially granting approval on November 7 for NASDAQ to list ETMF shares. Eaton Vance has created a structure that enjoys the benefits of ETFs’ lower operating costs and enhanced tax efficiencies, without the burden of daily disclosure requirements. Eaton Vance’s proposal persuaded the SEC that unlike the BlackRock and Precidian pricing mechanisms, the ETMF structure would keep the market share price sufficiently close to NAV because shares would trade at a premium or discount based directly off of the NAV. The SEC evidently was satisfied that this will adequately protect retail investors without the benefit of portfolio transparency.
Eaton Vance has obtained patents with respect to certain aspects of ETMF’s NAV-based trading pricing mechanism. Eaton Vance expects that investment advisers that desire to manage ETMFs will obtain a license from Eaton Vance and apply for a separate exemptive order from the SEC that incorporates by reference all the terms and conditions of Eaton Vance’s order.[1]
Precidian Refiles
In the wake of the SEC’s notice of its intent to deny Precidian’s application, Precidian decided to pull its original application and refile with the hope of addressing the SEC’s main concern, namely keeping the market price of ETF shares close to NAV. The first innovation of Precidian’s application is that each authorized participant would establish a blind trust to transact on its behalf with the ETF. The ETF’s portfolio holdings would be fully transparent to the blind trusts, which would allow them to calculate and convey a close approximation of the actual NAV to authorized participants. This mechanism would allow ETFs to maintain confidentiality from the public at large while maintaining a mechanism that would presumably keep the market share price close to NAV.
The second innovation advanced by Precidian’s application is the verified intraday indicative value (VIIV). VIIV differs from IIV in that it will be calculated based on the currently quoted bid/ask midpoint price of the underlying securities (as opposed to the last sale of the underlying securities) and will include all accrued income and expenses of the fund in share quotes. Precidian asserts in its application that this will increase price reliability and accuracy. The funds will disclose to the blind trusts the identity of the securities and other price inputs so they can independently calculate and verify the fund’s share price.
Looking Forward
Now that Eaton Vance has successfully run the SEC’s regulatory gauntlet, the next question is whether investors will want to invest in actively managed ETMFs. In recent years, there has been a shift of investor capital away from actively managed mutual funds and ETFs towards index-based funds (including ETFs). Moreover, there will be a learning curve as investors try to comprehend the novel and somewhat complex pricing structure of ETMFs. Regardless, for many sponsors a “holy grail” has been accessing the ETF channel for actively managed strategies without full portfolio disclosure. Eaton Vance may have found it, and Precidian and others may not be far behind.
[1] We are not expressing a view on the strength or validity of such patents.