In a highly unusual regulatory action, the Securities and Exchange Commission (“SEC”) has stated in two formal notices that it intends to deny proposals that would permit an actively-managed exchange traded fund to operate without disclosing its portfolio holdings on a daily basis (“Non-Transparent ETF”). Presently, all actively-managed ETFs must disclose their holdings daily. Links to the SEC’s notices are available at the end of this article.
The SEC’s intention to deny each proposal is based on its preliminary view that the proposal does not provide an adequate substitute for portfolio transparency such that a Non-Transparent ETF would consistently trade at or close to net asset value (“NAV”). In the SEC’s view, each proposal’s lack of portfolio transparency or an adequate substitute for portfolio transparency coupled with a potentially deficient back-up mechanism (described below) presents a significant risk that the market prices of a Non-Transparent ETF’s shares may materially deviate from the NAV per share of the ETF — particularly in times of market stress when the need for verifiable pricing information becomes more acute. The SEC asserted this would be contrary to the foundational principle underlying certain provisions of the Investment Company Act of 1940 — that shareholders be treated equitably — and may, in turn, inflict substantial costs on investors, disrupt orderly trading and damage market confidence in the secondary trading of ETF shares.
Summary of the Proposals
Applicants requested an order from the SEC for relief to operate Non-Transparent ETFs noting that their request is similar to requests previously made by existing actively-managed ETFs, except for the following material differences that would permit their ETFs to operate on a non-transparent basis.
Prospectus and Portfolio Disclosures. Applicants would not provide the daily disclosure of a Non-Transparent ETF’s portfolio holdings that is a condition in all exemptive orders issued to existing actively managed ETFs. Applicants would instead only provide the standard portfolio and other disclosures required for traditional mutual funds.
Indicative Intraday Value. Investors and others acquiring a Non-Transparent ETF’s shares would primarily have to rely on the intraday indicative value (the “IIV”), which would be disseminated by an exchange every 15 seconds during the trading day, to assess the value of the Non-Transparent ETF due to the lack of portfolio transparency. IIV is not intended as a “real-time NAV.”
Blind Trust Mechanism. Applicants proposed for creation unit purchases to be made in cash and for redemptions to be effected in-kind through a “blind trust” established for each Authorized Participant. Applicants asserted that the delivery of redemption securities into the blind trust would allow the ETF to retain the benefits associated with in-kind redemptions, while shielding the identity of the ETF’s portfolio securities.
Back-up Redemption Option. Applicants proposed a back-up mechanism that would allow retail investors to redeem individual shares directly from a Non-Transparent ETF in the event of a significant deviation of closing market price from NAV. Under each proposal, retail investors exercising the option would be subject to a redemption fee of up to 2% of the value of shares redeemed and would likely be charged additional brokerage commissions.
SEC’s Analysis of the Proposals
The SEC first observed that the specific features proposed by the Applicants that would cause the Non-Transparent 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 then examined with a critical eye each of those specific features.
Prospectus Disclosure and IIV Dissemination. Applicants asserted that prospectus disclosure and the dissemination of the IIV every 15 seconds during the trading day would be sufficient to allow the arbitrage mechanism to function effectively after a few days of trading. The SEC disagreed. In the SEC’s view, prospectus disclosure will not assist the arbitrage mechanism because it does not contain any material real-time information necessary to creating or facilitating effective arbitrage. Moreover, the lack of information more specific than what is disclosed in a prospectus about a Non-Transparent ETF’s investment objectives or principal investment strategies may not enable market makers to effectively assess whether real-time arbitrage opportunities in ETF shares exist and may discourage them from making markets in ETF shares that would keep the share prices at or close to the NAV per share of the ETF — a condition that may be exacerbated during times of market stress.
The SEC then asserted that dissemination of the IIV at 15 second intervals throughout the trading day does not fill this information void. The SEC explained that market participants typically use IIV as a secondary or even tertiary check on values created by their proprietary algorithms, which rely on daily portfolio holdings disclosure and available pricing information to calculate an ETF’s estimated NAV per share. The SEC, in great detail, further asserted that the reliability of IIV as a primary pricing signal for Non-Transparent ETFs would, at best, be questionable.
Quarterly Release of Portfolio Holdings. Applicants had also proposed providing their portfolio holdings disclosures on a quarterly basis, with a lag of not more than 60 days. In the SEC’s view, those disclosures would quickly lose their relevance for purposes of valuing or hedging the Non-Transparent ETFs because the content of their portfolios can change on a daily basis.
Back-Up Redemption Option. In the SEC’s view, the redemption option does not remedy the perceived defects of the proposal noted above. Under the proposal, retail investors exercising the redemption option would be subject to redemption and brokerage fees. The SEC believes these fees and costs may dissuade retail investors from exercising an option meant to provide them with the ability to transact with the ETF on an equal footing with the Authorized Participants.
The SEC continued on the topic of the redemption option by explaining that, even if Applicants were able to address the SEC’s concerns about the redemption option, it would not address the SEC’s more fundamental concerns about the overall proposal — that is, an ETF model that the SEC preliminarily believes would not have a sufficiently effective arbitrage mechanism to consistently produce a secondary market price for investors that would approximate NAV per share of the ETF. In the SEC’s view, the presence of a back-up retail redemption option does not cure the inherently flawed structure of the proposed Non-Transparent ETFs.
The SEC stated it would deny each Applicants’ proposal in the absence of a request for a hearing that is granted by the SEC. Interested parties have until November 17, 2014, to make such a request. We will closely monitor the after-effects of the SEC’s action and report on any noteworthy developments.
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This article was originally published by Bingham McCutchen LLP.