Earlier this year, the Securities and Exchange Commission issued the first exemptive order permitting the operation of actively managed exchange-traded funds that do not disclose their full holdings daily. This order and other pending applications have garnered a significant amount of attention, including from active managers that previously were deterred from launching ETFs as a result of the daily holdings disclosure requirements.
This article discusses considerations for boards with respect to the launch and oversight of non-fully transparent active ETFs. While considerations involving these ETFs are in many ways similar to other active mutual funds and/or ETFs, the unique nature of this particular structure results in certain additional considerations. Further, the exemptive relief sets forth certain specific obligations with respect to board oversight of ETFs relying on the relief. These considerations and obligations are discussed below.
ETFs historically have operated pursuant to exemptive relief from certain provisions of the Investment Company Act of 1940. More recently, the SEC adopted Rule 6c-11 under the 1940 Act, which eliminates the need for individual exemptive orders for ETFs that meet the conditions of the rule. One of the conditions under prior exemptive orders relating to active ETFs, as well as under Rule 6c-11, is that an ETF must disclose its full holdings on a daily basis. The SEC has viewed this requirement as important to the arbitrage mechanism that results in shares of an ETF generally trading at or close to their net asset value. Based on information about the market value of an ETF’s holdings, authorized participants and other market participants are able to trade profitably on differences between the market price and NAV of shares in ways that tend to move market price closer to NAV. For example, where shares of an ETF are trading at a premium to NAV, authorized participants can purchase shares directly from the ETF at NAV and realize a profit by selling the shares in the secondary market at the higher market price, increasing the supply of shares and lowering their market price.
In contrast to the exemptive orders requiring full portfolio transparency, various exemptive applications have been filed over time proposing different mechanisms designed to provide sufficient information to the market to facilitate effective arbitrage without disclosing full holdings information. In general, these fall into two broad categories: (i) the approach proposed by Precidian Funds, LLC involving disclosure of a “verified intraday indicative value” (VIIV) throughout the day, together with in-kind creations and redemptions by authorized participants utilizing confidential accounts maintained by certain broker-dealers (AP Representatives) for the benefit of the authorized participants (Precidian model); and (ii) various proposals involving disclosure of information about a “proxy basket,” a basket of instruments that is designed to closely track the performance of the ETF’s portfolio, and which would also serve as the ETF’s creation and redemption basket.
To date, the SEC has granted relief only with respect to the Precidian model, although several proxy basket applications remain pending, and many of these applications have recent regulatory activity. The following discusses considerations and obligations relating to ETFs utilizing the Precidian model or a proxy basket approach generally (in the latter case, based on recent exemptive application filings). We note, however, that the specific considerations for a given proxy basket approach may vary from application to application.
Board Consideration of Launch Proposals
From a board’s perspective, a proposal to launch a non-fully transparent active ETF will largely be similar to other new fund launch proposals, with the investment adviser providing information about the proposed ETF’s investment strategy, fees and expenses (including comparative information), and distribution opportunities, among other matters. However, the different way in which the ETF will operate may raise additional considerations, such as the following:
- Appropriateness of strategy for product structure. The board may want to understand the investment adviser’s process for determining that the proposed strategy is appropriate for the structure (i.e., that the information to be disclosed to the marketplace is sufficient to facilitate arbitrage, but will not easily allow for reverse engineering of the strategy).
- Investment limitations. The Precidian order (and, in general, the proxy basket applications) largely limit investments to U.S. exchange-traded equity securities. Accordingly, to the extent the investment adviser proposes to utilize an existing investment strategy with respect to the ETF, the board may want to understand whether the investment limitations imposed under the exemptive relief will require modifications to the existing strategy. Similarly, where the board is provided with prior performance information for that strategy, directors may want to ask about the limitations of that performance information in light of planned strategy modifications.
- Operational framework. Particularly where the ETF will be the first non-fully transparent active ETF sponsored by the investment adviser, the board may want to consider the investment adviser’s operational readiness, including with respect to VIIV disclosure and arrangements with AP Representatives (in the case of ETFs utilizing the Precidian model) or determination of the proxy basket.
- Existence of a similar mutual fund. To the extent the investment adviser sponsors a mutual fund utilizing the same strategy, it would be appropriate to compare the ETF’s proposed fees and expenses to those of the mutual fund. If the management fee for the ETF would differ from that of the mutual fund, both the ETF board and mutual fund board should have an understanding of the rationale for the difference. For example, many ETFs have unitary fee arrangements with their investment advisers whereby the investment adviser pays the ETF’s operating expenses, which may result in different fee arrangements for ETFs and mutual funds utilizing similar strategies.
- Distribution strategy. A board may want to discuss the distribution strategy for the ETF with the investment adviser and/or distributor, including expectations as to platform and intermediary arrangements. Where the investment adviser sponsors a similar mutual fund, a board also may want to understand how the distribution strategies and opportunities for the ETF differ, if at all, from those involving the mutual fund.
Where a board does not already oversee ETFs, the above are in addition to more general considerations with respect to the launch of an ETF complex. Where the ETFs will be the first in the fund complex, the board should become familiar with the product structure and how it differs from mutual funds or other products they oversee. This might include an understanding of the ETF industry, the creation and redemption process, and the role of market participants (such as market makers and authorized participants) in facilitating the arbitrage function, among other matters. The board may want to work with the investment adviser on appropriate periodic reporting tied specifically to the ETF product structure (such as reports on trading in an ETF’s shares and creation/redemption activity).
To the extent a proposed ETF will be the first overseen by the board, it will also be the first time the board is asked to approve service providers for ETFs, certain of which may differ from the service providers engaged with respect to other funds they oversee. For example, many new ETF market entrants hire a third-party distributor that is familiar with the ETF creation and redemption process, even where mutual funds in the same fund family employ a distributor that is affiliated with the investment adviser. In addition, the board would be asked to approve the adoption and/or amendment of compliance policies and procedures generally with respect to the ETF structure (as well as the specific procedures discussed in the next section). In connection therewith, the board may want to consider how the investment adviser is approaching ETF-specific requirements such as exchange listing rules, which impose certain reporting and other obligations on an ETF.
Compliance Policies and Procedures
The compliance policies and procedures to be adopted for a non-fully transparent active ETF are based on the requirements of Rule 38a-1 under the 1940 Act generally, as well as the specific requirements of the ETF’s exemptive order. The board may be asked to approve the following in connection with a proposal to launch a non-fully transparent active ETF:
- VIIV/proxy basket procedures. The Precidian order and proxy basket applications contemplate certain procedures tied to the alternative to daily holdings disclosure employed by an ETF. Under Precidian’s exemptive order, an ETF must adopt procedures governing the calculation and dissemination of the VIIV as part of its compliance program and subject to the provisions of Rule 38a-1. Under the proxy basket applications, an ETF generally must adopt procedures governing the construction of its proxy basket, also as part of its compliance program and subject to the provisions of Rule 38a-1.
- Basket procedures. The Precidian order and proxy basket applications also require adoption of policies and procedures under Rule 38a-1 governing the composition of an ETF’s creation and redemption baskets, which must set forth detailed parameters for the construction and acceptance of baskets that are in the best interests of the ETF. Notably, the Precidian order does not (and the proxy basket applications generally would not) permit the level of flexibility with respect to the use of “custom baskets” that is permitted by Rule 6c-11. In particular, the order and applications provide flexibility to substitute cash for basket instruments, but do not provide the broader flexibility afforded by the rule with respect to non-pro rata baskets.
Ongoing Board Oversight
A board’s ongoing oversight of a non-fully transparent active ETF will largely be similar to its oversight of other funds, but with certain additional requirements pursuant to the ETF’s exemptive relief. Significantly, the Precidian order and proxy basket applications generally impose monitoring obligations on the investment adviser, together with required considerations on the part of the board. These requirements are designed to address a potential breakdown of the arbitrage mechanism, as evidenced by widening bid/ask spreads and/or large premiums or discounts (or, in the case of the proxy basket applications, performance differentials between the proxy basket and actual portfolio).
Specifically, for at least the first three years after launch of an ETF operating in reliance on the relief, the investment adviser must promptly call a meeting of the board if, for 30 or more days in any quarter or 15 days in a row, either of the following exceeds 1.00% (Precidian order) or 2.00% (proxy basket applications) or such lesser threshold adopted by the board: (i) the absolute difference between either the market closing price or bid/ask price, on one hand, and NAV, on the other; or (ii) the bid/ask spread. The proxy basket applications generally also require that a meeting be called in the event the tracking error between the proxy basket and actual portfolio exceeds 1.00%. In the event a threshold is triggered, the investment adviser must present recommendations for appropriate remedial measures to the board for its consideration, and the board must consider: (i) the continuing viability of the ETF; (ii) whether shareholders are being harmed; and (iii) what, if any, action would be appropriate. In addition, regardless of whether a threshold is triggered, the board must undertake these considerations annually for at least the first three years following launch.
The action, if any, to be taken in the event a threshold is triggered will depend on the relevant facts and circumstances, including whether there is an ongoing issue with a threshold being reached or the triggering event is a one-time occurrence due to market events. The Precidian order and proxy basket applications do, however, provide some specific examples of actions that might be taken. These include: changes associated with the listing and trading of shares (changing the lead market maker or listing the ETF on a different exchange); changes to the creation unit size, which could potentially encourage more authorized participant activity in the ETF; changes to the ETF’s investment objective or strategy; in the case of the proxy basket applications, changes to the proxy basket process; and liquidation of the ETF.
Boards may want to work with investment advisers on appropriate periodic reporting relating to premiums/discounts, bid/ask spreads, and authorized participant activity. This will assist directors in overseeing the effectiveness of the arbitrage mechanism and may help identify scenarios where a threshold might be triggered in the future. Directors also may want to engage in a regular dialogue with the investment adviser about the effectiveness of the arbitrage function and remedial measures the investment adviser might recommend if a threshold is triggered, so that directors are prepared in the event a threshold is subsequently triggered and a meeting is called.
As noted above, there are certain unique board considerations that result from the way in which non-fully transparent active ETFs operate and the requirements of their exemptive relief. Boards therefore should be mindful of these operational differences and regulatory requirements in exercising oversight of these ETFs.
Mark D. Perlow is a partner in Dechert’s San Francisco office; he represents mutual funds, hedge fund managers, fund independent directors, investment advisers, and broker-dealers on a broad range of regulatory and transactional matters. Based in Boston, Stephanie A. Capistron is a partner who advises U.S. registered investment companies and their investment advisers on a wide variety of regulatory, compliance and corporate matters, including the development and launch of new funds, regulatory and compliance matters relating to existing funds, fund reorganizations and requests for exemptive relief from the Securities and Exchange Commission. Margaret E. Wilson is an associate in the financial services group in New York, advising U.S. registered investment companies, including mutual funds, exchange-traded funds, closed-end funds and business development companies and their investment advisers on a wide variety of regulatory, compliance and business matters.