
[Federal Register Volume 79, Number 207 (Monday, October 27, 2014)]
[Notices]
[Pages 63964-63971]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-25438]


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SECURITIES AND EXCHANGE COMMISSION

[Investment Company Act Release No. 31301; 812-13953]


Spruce ETF Trust, et al.; Notice of Application

October 21, 2014.
AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Notice of an application for exemptive relief.

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SUMMARY OF APPLICATION:  Applicants request an order under section 6(c) 
of the Investment Company Act of 1940 (``Act'') for an exemption from 
sections 2(a)(32), 5(a)(1), 22(d) and 22(e) of the Act and rule 22c-1 
under the Act, under sections 6(c) and 17(b) of the Act for an 
exemption from sections 17(a)(1) and 17(a)(2) of the Act, and under 
section 12(d)(1)(J) of the Act for an exemption from sections 
12(d)(1)(A) and (B) of the Act. If granted, the requested order would 
permit several registered open-end investment companies that are 
actively managed exchange traded funds (each, an ``ETF'') to list and 
trade without being subject to the current daily portfolio transparency 
condition in actively managed ETF orders.

APPLICANTS:  Spruce ETF Trust (the ``Trust''), BlackRock Fund Advisors 
(the ``Adviser'') and BlackRock Investments, LLC (the ``Distributor'') 
(together, the ``Applicants'').

FILING DATE:  The application was filed on September 1, 2011.

HEARING OR NOTIFICATION OF HEARING:  Interested persons may request a 
hearing by writing to the Commission's Secretary and serving applicants 
with a copy of the request, personally or by mail. Hearing requests 
should be received by the Commission by 5:30 p.m. on November 17, 2014, 
and should be accompanied by proof of service on applicants, in the 
form of an affidavit or, for lawyers, a certificate of service. 
Pursuant to rule 0-5 under the Act, hearing requests should state the 
nature of the writer's interest, any facts bearing upon the 
desirability of a hearing on the matter, the reason for the request, 
and the issues contested. Persons who wish to be notified of a hearing 
may request notification by writing to the Commission's Secretary. 
Absent a request for a hearing that is granted by the Commission, the 
Commission intends to issue an order under the Act denying the 
application.

ADDRESSES: Secretary, U.S. Securities and Exchange Commission, 100 F 
Street NE., Washington, DC 20549-1090. Applicants: c/o BlackRock Fund 
Advisors, 400 Howard Street, San Francisco, California 94105.

FOR FURTHER INFORMATION CONTACT: Deepak T. Pai, Senior Counsel; Kay-
Mario Vobis, Senior Counsel; or Dalia Osman Blass, Assistant Chief 
Counsel, at (202) 551-6821 (Division of Investment Management, Chief 
Counsel's Office).

SUPPLEMENTARY INFORMATION: The following is a summary of the 
application. The complete application may be obtained via the 
Commission's Web site by searching for the file number, or an applicant 
using the Company name box, at http://www.sec.gov/search/search.htm or 
by calling (202) 551-8090.

I. Introduction

    1. Applicants seek to introduce a novel type of actively managed 
exchange-traded fund (``ETF'') that would not be required to disclose 
its portfolio holdings on a daily basis. Due to their characteristics, 
ETFs (including those proposed by Applicants) are only permitted to 
operate subject to Commission orders that provide exemptive relief from 
certain provisions of the Act and rules thereunder.\1\ Accordingly, 
Applicants seek an order under section 6(c) of the Act for an exemption 
from sections 2(a)(32), 5(a)(1), 22(d) and 22(e) of the Act and rule 
22c-1 thereunder; and under sections 6(c) and 17(b) of the Act granting 
an exemption from sections 17(a)(1) and 17(a)(2) of the Act, and under 
section 12(d)(1)(J) for an exemption from sections 12(d)(1)(A) and (B) 
of the Act.
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    \1\ The Commission first granted exemptive relief to operate 
ETFs in the early 1990s when the first index-based ETFs were 
developed. See SPDR Trust Series I, Investment Company Act Release 
Nos. 18959 (Sept. 17, 1992) (notice) and 19055 (Oct. 26, 1992) 
(order).
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    2. As discussed below, the Commission preliminarily believes that 
Applicants' proposed ETFs do not meet the standard for exemptive relief 
under section 6(c) of the Act. Section 6(c) allows the Commission to 
exempt any person, security, or transaction, or any class thereof, only 
``if and to the extent that such exemption is necessary or appropriate 
in the public interest and consistent with the protection of investors 
and the purposes fairly intended by the policy and provisions of [the 
Act].'' \2\ Accordingly, the Commission preliminarily intends to deny 
the application.\3\
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    \2\ 15 U.S.C. 80a-6(c).
    \3\ For this reason, the Commission finds it unnecessary to 
consider whether the application meets the section 17(b) and section 
12(d)(1)(J) standards for exemptive relief.
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II. Background

A. Open-End Investment Companies and Net Asset Value

    3. The Act defines an investment company as an ``issuer'' of ``any 
security'' which ``is or holds itself out as being engaged primarily . 
. . in the business of investing . . . in securities.'' \4\ Shares in 
an investment company represent proportionate interests in its 
investment portfolio, and their value fluctuates in relation to the 
changes in the value of that portfolio.
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    \4\ 15 U.S.C. 80a-3(a); 80a-3(a)(1).
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    4. The most common form of investment company, the ``open-end''

[[Page 63965]]

investment company or mutual fund, is required by law to redeem its 
securities on demand at a price approximating their proportionate share 
of the fund's net asset value (``NAV'') at the time of redemption.\5\ 
These funds also continuously issue and sell new shares, thereby 
replenishing their investment capital.
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    \5\ Section 22(d) of the Act prohibits a dealer from selling a 
redeemable security that is being offered to the public by or 
through an underwriter other than at a current public offering price 
described in the fund's prospectus. Rule 22c-1 under the Act 
requires open-end funds, their principal underwriters, and dealers 
in fund shares (and certain others) to sell and redeem fund shares 
at a price based on the current NAV next computed after receipt of 
an order to buy or redeem. Together, these provisions are designed 
to require that fund shareholders be treated equitably when buying 
and selling their fund shares.
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    5. Because open-end investment companies are required by law to 
redeem their shares based on investors' demands, shares of the funds 
have historically not traded on exchanges or in other secondary 
markets.\6\
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    \6\ This stems from section 22(d) of the Act, which in effect 
fixes the prices at which redeemable securities, including open-end 
shares, are sold. The result is a system that precludes dealers from 
making a secondary market in open-end shares.
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B. Exemptions Under the Act for Actively Managed ETFs

    6. ETFs, including those proposed by Applicants, are a type of 
open-end fund. But unlike traditional open-end funds, ETFs are made 
available to investors primarily through secondary market transactions 
on exchanges.
    7. In order for this to take place, ETFs require various exemptions 
from the provisions of the Act and the rules thereunder. Critically, in 
granting such exemptions to date, the Commission has required that a 
mechanism exist to ensure that ETF shares would trade at a price that 
is at or close to the NAV per share of the ETF.\7\
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    \7\ This has been a required representation in all ETF orders 
since the Commission issued the first order. See supra note 1.
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    8. Such a mechanism is essential for ETFs to operate because ETFs 
do not sell or redeem their individual shares at NAV per share as 
required by the Act. Instead, large broker-dealers that have 
contractual arrangements with an ETF (each, an ``Authorized 
Participant'') purchase and redeem ETF shares directly from the ETF, 
but only in large blocks called ``creation units.'' An Authorized 
Participant that purchases a creation unit of ETF shares first deposits 
with the ETF a ``basket'' of securities and other assets (e.g., cash) 
identified by the ETF that day, and then receives the creation unit of 
ETF shares in return for those assets. The basket is generally 
representative of the ETF's portfolio and is equal in value to the 
aggregate NAV of ETF shares in the creation unit. After purchasing a 
creation unit, the Authorized Participant may sell the component ETF 
shares in secondary market transactions. Investors then purchase 
individual shares in the secondary market. The redemption process is 
the reverse of the purchase process: the Authorized Participant 
acquires a creation unit of ETF shares and redeems it for a basket of 
securities and other assets.
    9. The combination of the creation and redemption process with the 
secondary market trading in ETF shares provides arbitrage opportunities 
that, if effective, keep the market price of the ETF's shares at or 
close to the NAV per share of the ETF.\8\ For example, if an ETF's 
shares begin trading on national securities exchanges at a ``discount'' 
(a price below the NAV per share of the ETF), an Authorized Participant 
can purchase ETF shares in secondary market transactions and, after 
accumulating enough shares to comprise a creation unit, redeem them 
from the ETF in exchange for the more valuable securities in the ETF's 
redemption basket. In addition to purchasing ETF shares, Authorized 
Participants also are likely to hedge their intraday risk. Thus, for 
example, when ETF shares are trading at a discount to the NAV per share 
of the ETF, an Authorized Participant may also simultaneously short the 
securities in the redemption basket. At the end of the day, the 
Authorized Participant will return the creation unit of ETF shares to 
the ETF in exchange for the ETF's redemption basket of securities and 
other assets, which it will then use to cover its short positions. 
Those purchases reduce the supply of ETF shares in the market, and thus 
tend to drive up the market price of the shares to a level closer to 
the NAV per share of the ETF.\9\
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    \8\ See Investment Company Institute, 2014 Investment Company 
Fact Book (2014) (``ICI Fact Book''), at 60.
    \9\ The Authorized Participant's purchase of the ETF shares in 
the secondary market, combined with the sale of the redemption 
basket securities, may also create upward pressure on the price of 
ETF shares and/or downward pressure on the price of redemption 
basket securities, driving the market price of ETF shares and the 
value of the ETF's portfolio holdings closer together.
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    10. Conversely, if the market price for ETF shares reflects a 
``premium'' (a price above the NAV per share of the ETF), an Authorized 
Participant can deposit a basket of securities in exchange for the more 
valuable creation unit of ETF shares, and then sell the individual 
shares in the market to realize its profit. An Authorized Participant 
may also hedge its intraday risk when ETF shares are trading at a 
premium. Thus, for example, when the shares of an ETF are trading at a 
premium, an Authorized Participant may buy the securities in the 
purchase basket in the secondary market and sell short the ETF shares. 
At the end of the day, the Authorized Participant will deposit the 
purchase basket of securities and other assets in exchange for a 
creation unit of ETF shares, which it will then use to cover its short 
positions. The Authorized Participant will receive a profit from having 
paid less for the ETF shares than it received for the securities in the 
purchase basket. These transactions would increase the supply of ETF 
shares in the secondary market, and thus tend to drive down the price 
of ETF shares to a level closer to the NAV per share of the ETF.\10\
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    \10\ The Authorized Participant's purchase of the purchase 
basket securities, combined with the sale of ETF shares, may also 
create downward pressure on the price of ETF shares and/or upward 
pressure on the price of purchase basket securities, bringing the 
market price of ETF shares and the value of the ETF's portfolio 
holdings closer together.
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    11. Market participants can also engage in arbitrage activity 
without using the creation or redemption processes described above. For 
example, if a market participant believes that an ETF is overvalued 
relative to its underlying or reference assets, the market participant 
may sell short ETF shares and buy the underlying or reference assets, 
wait for the trading prices to move toward parity, and then close out 
the positions in both the ETF shares and the underlying or reference 
assets to realize a profit from the relative movement of their trading 
prices. Similarly, a market participant could buy ETF shares and sell 
the underlying or reference assets in an attempt to profit when an 
ETF's shares are trading at a discount to the ETF's underlying or 
reference assets. As discussed above, the trading of an ETF's shares 
and the ETF's underlying or reference assets may bring the prices of 
the ETF's shares and its portfolio assets closer together through 
market pressure.
    12. In assessing whether to grant exemptive relief to actively 
managed ETFs in the past, the Commission has required a mechanism that 
would keep the market prices of ETF shares at or close to the NAV per 
share of the ETF. To date, this mechanism has been dependent on daily 
portfolio transparency.\11\ This transparency

[[Page 63966]]

provides market makers and other market participants with an important 
tool to value the ETF portfolio on an intraday basis, which, in turn, 
enables them to assess whether an arbitrage opportunity exists. It is 
the exercise of such arbitrage opportunities that keeps the market 
price of ETF shares at or close to the NAV per share of the ETF. This 
close tie between market price and NAV per share of the ETF is the 
foundation for why the prices at which retail investors buy and sell 
ETF shares are similar to the prices at which Authorized Participants 
are able to buy and redeem shares directly from the ETF at NAV. In 
granting relief from section 22(d) of the Act and rule 22c-1 under the 
Act, the Commission relies on this close tie between what retail 
investors pay and what Authorized Participants pay to make the finding 
that the ETF's shareholders are being treated equitably when buying and 
selling shares.\12\ The Commission therefore has granted such exemptive 
relief to date only to those actively managed ETFs that have provided 
daily transparency of their portfolio holdings.
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    \11\ The condition for daily portfolio transparency has 
consistently been one of the conditions to the exemptive relief 
issued to actively managed ETFs by the Commission. See PowerShares 
Capital Management LLC, et al., Investment Company Act Release Nos. 
28140 (Feb. 1, 2008) (notice) and 28171 (Feb. 27, 2008) (order).
    \12\ See supra note 5 and accompanying text.
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III. The Application

A. The Applicants

    13. The Trust is a business trust organized under the laws of 
Delaware and will be registered under the Act as an open-end management 
investment company with multiple series (each, a ``proposed ETF''). 
Applicants propose to offer 13 initial proposed ETFs, each of which 
will use a variety of active management strategies to meet its 
investment objectives. The proposed ETFs include long/short funds, and 
may invest a portion of their assets (up to a third of the total 
assets) in derivatives and foreign securities.\13\
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    \13\ See Securities Exchange Act Release No. 34-72787 (Aug. 7, 
2014), File No. SR-BATS-2014-018 (``19b-4 Notice''), at 14-15.
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    14. The Adviser, a corporation organized under the laws of 
California, is registered as an investment adviser under the Investment 
Advisers Act of 1940 (``Advisers Act'') and would serve as the 
investment adviser to the initial proposed ETFs. The Distributor, a 
Delaware limited liability company, is a registered broker-dealer under 
the Securities Exchange Act of 1934, as amended.

B. Applicants' Proposal

    15. Applicants seek exemptive relief under section 6(c) of the Act 
to allow them to introduce several actively managed ETFs that would not 
disclose their portfolio holdings on a daily basis. Applicants note 
that actively managed ETFs with transparent portfolios are susceptible 
to ``front running'' and ``free riding'' by other investors and/or 
managers which can harm, and result in substantial costs to, the 
actively managed ETFs.\14\
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    \14\ Application at 40. See also Murray Coleman, Could a Stock 
ETF Cloak its Portfolio (May 7, 2012), available at http://online.wsj.com/news/articles/SB10001424052702304432704577348261039833588 (noting that if traders 
can identify the shares in which a fund manager is building a 
position, they can start buying the shares ahead of the manager and 
drive up the price while the manager is still buying the stock).
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    16. As explained below, the Applicants propose to operate actively 
managed ETFs that would not disclose their portfolio holdings on a 
daily basis. Applicants state that the relief requested in their 
application is similar to the relief granted in exemptive orders issued 
to existing actively managed ETFs, except for certain differences 
permitting the proposed ETFs to operate on a non-transparent basis. 
These material differences are highlighted below:
    a. Prospectus and Portfolio Disclosures: Applicants would not 
provide the daily disclosure of a proposed 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. 
Traditional mutual funds are required to disclose their portfolio 
holdings only on a quarterly basis, with a lag of not more than 60 
days.\15\
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    \15\ Shareholder reports, including a schedule of portfolio 
holdings, must be transmitted to shareholders semi-annually, within 
60 days of the end of the second and fourth fiscal quarters. See 
Rule 30e-1. A complete schedule of portfolio holdings must be filed 
with the Commission on Form N-CSR within 10 days of the transmission 
of the shareholder report. See Rule 30d-1. Complete portfolio 
holdings also must be filed on Form N-Q within 60 days of the end of 
the first and third fiscal quarters. See Rule 30b1-5.
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    b. Indicative Intraday Value: Investors and others acquiring the 
proposed ETFs' 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,\16\ to assess the 
value of a proposed ETF due to the lack of portfolio transparency. The 
IIV would be calculated by a calculation agent who would receive the 
daily list of securities constituting the proposed ETF's portfolio from 
the ETF sponsor.\17\ As acknowledged by the Applicants, the IIV is 
based on the value of the proposed ETF's portfolio and is calculated by 
the calculation agent using the last available market quotation or sale 
price of the proposed ETF's portfolio holdings.\18\ As further 
acknowledged by the Applicants, the IIV is not the NAV; rather, it is a 
reference produced by a third party seeking to approximate the proposed 
ETF's underlying per share net asset value.\19\ Applicants also concede 
that the IIV is not intended as a ``real-time NAV'' and (unlike the 
NAV) would not include extraordinary expenses or liabilities booked 
during the day.\20\ As discussed below, an ETF's portfolio could 
contain securities and other assets all (or most) of which need to be 
fair valued in order for the IIV to be accurate.\21\
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    \16\ We note that the IIV is not disseminated during early and 
late trading sessions when market participants would still be 
trading the proposed ETFs' shares. Therefore, there would be no 
pricing signal at all for these trades.
    \17\ See infra note 35.
    \18\ Application at 32. See also Matt Hougan, The Flaws in iNAV, 
104 Exchange-Traded Funds Report (``Hougan ETF Report''), 5, 10 
(2009).
    \19\ Application at 31.
    \20\ Id.
    \21\ See infra notes 38-45 and accompanying text.
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    c. Blind Trust Mechanism: Applicants propose 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 assert that the delivery of redemption securities into the 
blind trust would allow the ETF to retain the benefits associated with 
in-kind redemptions,\22\ while shielding the identity of the ETF's 
portfolio securities. Based on the standing instructions of the 
Authorized Participant, the blind trust would sell or otherwise manage 
the securities on behalf of the Authorized Participant without 
disclosing the contents of the underlying portfolio.
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    \22\ Because redemptions from ETFs are often made in-kind, ETFs 
may offer certain tax efficiencies compared to traditional mutual 
funds by avoiding the need to sell assets and potentially experience 
a taxable event. In addition, ETFs do not bear the brokerage costs 
associated with liquidating portfolio instruments to meet redemption 
requests. We note that it is unclear whether Applicants' proposed 
ETFs would experience the same in-kind benefits experienced by 
existing ETFs. The blind trust structure is likely to introduce 
additional costs because, among other things, the Authorized 
Participants would not be able to manage the sale of the securities 
to enhance arbitrage profits. See Comment Letter of Gary Gastineau, 
File No. SR-NYSEArca-2014-10 (Mar. 18, 2014) (``Gastineau March 2014 
Letter''), at 3-5 for a discussion of the potential issues presented 
by this structure.
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    d. Back-up Redemption Option: Applicants have proposed a back-up 
mechanism that would allow retail investors to redeem individual shares 
directly from the proposed ETFs in the event of a persistent and 
significant

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deviation of closing market price from NAV. Under the 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. Further, the redemption option would 
become available to retail investors only after the proposed ETF's 
shares have persistently been trading at a discount of at least 5% from 
NAV for 10 consecutive business days. The option would remain open for 
15 days; if a discount persists, a new option would commence on the 
next business day.

IV. Analysis of the Application

    17. As noted above, the Applicants have sought exemptive relief 
under several provisions of the Act--each of which the Applicants would 
need to obtain in order to operate their proposed ETFs.
    18. Applicants state that the relief requested in their application 
is similar to the relief granted in exemptive orders issued to existing 
actively managed ETFs, except for certain differences permitting the 
proposed ETFs to operate on a non-transparent basis.
    19. As discussed below, however, the Commission preliminarily 
believes that 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.\23\ 
Accordingly, the Commission preliminarily believes that it is not in 
the public interest or consistent with the protection of investors or 
the purposes fairly intended by the policy and provisions of the Act to 
grant the exemptive relief under section 6(c) that the Applicants seek.
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    \23\ Staff in the Division of Economic and Risk Analysis 
provided advice and analyses relevant to the Commission's 
conclusions, discussed in more detail below.
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A. ETF Prospectus Disclosure and IIV Dissemination

    20. Applicants assert that ETF 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.\24\ Applicants further assert that market 
participants do not need any additional information about the proposed 
ETF's portfolio so long as they are able to create correlations against 
and, over time, evaluate how various market factors affect the 
disseminated IIV. According to Applicants, this process is referred to 
as ``reinforcement learning.''\25\
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    \24\ Application at 37-43.
    \25\ According to Applicants, reinforcement learning is 
dependent on statistical arbitrage. See text following supra note 
10. Applicants assert that market makers would use the proposed 
ETF's market price, IIV and daily NAV to construct a hedging 
portfolio for the proposed ETF. The market makers would then engage 
in statistical arbitrage between their hedging portfolio and the 
shares of the proposed ETF--i.e., buying and selling one against the 
other during the trading day and evaluating the effectiveness of 
their hedging portfolio at the day's end. Applicants further assert 
that after a few days of trading, there would be sufficient data for 
a market maker to run a statistical analysis that would result in 
the market maker's spreads being tightened substantially around the 
IIV. Application at 37-43.
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    21. ETF prospectus disclosure will not assist the arbitrage 
mechanism because such disclosure does not contain any material real-
time information necessary to creating or facilitating effective 
arbitrage. Actively managed funds generally include very broad 
investment objectives and strategies in order to provide investment 
advisers with the maximum flexibility possible in managing the 
portfolio, and do not include more specific, current information about 
a fund's portfolio holdings.\26\ The Commission preliminarily believes 
that it would be difficult, if not impossible, for market participants 
to discern sufficient useful information from such broad disclosures. 
Therefore, the lack of more specific information with respect to the 
proposed 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.
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    \26\ For example, Form N-1A requires mutual funds to disclose in 
the prospectus and statement of additional information their 
investment objectives or goals, principal investment strategies, and 
the portfolio turnover rate during the most recent fiscal year. See, 
e.g., Form N-1A, Items 2 to 4, and 9. As discussed above, mutual 
funds are required to disclose their portfolio holdings quarterly. 
See supra note 15 and accompanying text.
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    22. Dissemination of the IIV at 15 second intervals throughout the 
trading day does not fill this information void. Today, market makers 
calculate their own NAV per share of the ETF with proprietary 
algorithms that use an ETF's daily portfolio disclosure and available 
pricing information about the assets held in the ETF's portfolio.\27\ 
They generally use the IIV, if at all, as a secondary or tertiary check 
on the values that their proprietary algorithms generate. If the daily 
portfolio holdings for the proposed ETFs are not available for market 
makers to calculate current values of a proposed ETF, they will be 
reliant principally on the IIV given the limitations of the prospectus 
and quarterly portfolio disclosures. Even though the IIV continues to 
be disseminated in conjunction with the full portfolio holdings and 
basket of existing ETFs, its reliability as a primary pricing signal 
for the proposed ETFs is questionable for the reasons discussed below.
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    \27\ See David J. Abner, The ETF Handbook: How to Value and 
Trade Exchange Traded Funds (2010), at 90 (``[s]ince stock trading 
now takes place in microseconds, a lot can happen between two 
separate 15-second quotes. Professional traders are not using 
published IIVs as a basis for trading. Most, if not all, desks that 
are trading ETFs are calculating their own [NAV of the ETF] based on 
real time quotes . . . that they are generating within their own 
systems.''). See also Comment Letter of BGFA, File No. S7-07-08 (May 
16, 2008) (``BGFA 2008 Letter''), at n.43; and ICI Fact Book, supra 
note 8, at 59.
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    23. The IIV is stale data. Unlike market maker proprietary 
algorithms, which rely on portfolio transparency and provide market 
makers with real-time data to effectively trade in today's fast moving 
markets, IIV dissemination frequency is inadequate for purposes of 
making efficient markets in ETFs.\28\ Market makers operate at speeds 
calculated in fractions of a second.\29\ In today's markets, 15 seconds 
is too long for purposes of efficient market making and could result in 
poor execution.\30\

[[Page 63968]]

Because an ETF is a derivative security, its current value changes 
every time the value of any underlying component of the ETF portfolio 
changes.\31\ Therefore, the IIV for a more frequently traded component 
security might not effectively take into account the full trading 
activity for that security, despite being available every 15 seconds. 
For example, a large buy order for a component security held by the 
proposed ETF could temporarily spike the price of that security and, 
therefore, inflate the proposed ETF's contemporaneous IIV 
calculation.\32\ The IIV for the proposed ETF cannot adjust for such 
variations, whereas the NAV would.\33\ Therefore, relying on a stale 
IIV as a primary pricing signal for market making in Applicants' 
proposed ETFs would not result in an effective arbitrage mechanism.\34\
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    \28\ The Commission previously issued a proposing release on a 
proposed rule for certain ETFs. See Exchange-Traded Funds, 
Investment Company Act Release No. 28193 (Mar. 11, 2008) (``2008 ETF 
Rule Proposal''). Various industry members commenting on the 2008 
ETF Rule Proposal noted that market makers did not rely on the IIV 
because of either its staleness or unreliability. See, e.g., Comment 
Letter of NYSE Arca, Inc., File No. S7-07-08 (May 29, 2008) (the 
exchange noted that it ``is not convinced that the [IIV] is a 
meaningful pricing tool for investors in light of the availability 
of other pricing information. In fact, we believe that it is the 
transparency of the portfolios [sic] holdings which permit [sic] 
market makers and other professionals to arbitrage efficiently and 
not the regular dissemination of an [IIV]. Some market participants 
may choose to generate an [IIV] for their own use, using their own 
calculation methodology to include financing costs, capital costs, 
etc., in kind trading or arbitrage. Importantly, the [IIV] generated 
by professionals is in real-time and not delayed by 15 or 60 
seconds.''); and BGFA 2008 Letter, supra note 27, at n. 43 and n. 
92. See also Matt Hougan, Ban iNAVs For ETFs (June 24, 2013), 
available at http://www.indexuniverse.com/sections/blog/19037-hougan-ban-inavs-for-etfs.html.
    \29\ See Comment Letter of ICI, File No. SR-NASDAQ-2012-117 
(Nov. 8, 2012), (``ICI 2012 Letter''), at 4. See also ICI Fact Book, 
supra note 8.
    \30\ See, e.g., How To Minimize Your Cost Of Trading ETFs (June 
22, 2009), ETF.com, available at http://www.etf.com/publications/journalofindexes/joi-articles/6042-how-to-minimize-your-cost-of-trading-etfs.html, at Figure 2 and related discussion. See also ICI 
2012 Letter, supra note 29 (``Professional equity traders operate at 
speeds calculated in fractions of a second. In such markets, 15 
seconds can be an eternity, and establishing an order price based on 
data that is nearly 15 seconds old could result in poor 
execution.'').
    \31\ In particularly volatile markets, the dissemination lag of 
IIV values (i.e., every 15 seconds) may misrepresent the actual 
value of the ETF. See Understanding iNAV, ETF.com, available at 
http://www.etf.com/etf-education-center/21028-understanding-inav.html; Gary L. Gastineau, Exchange-Traded Funds Manual, Second 
Edition (2010), at 200-202.
    \32\ See, e.g., ICI 2012 Letter, supra note 29.
    \33\ See, e.g., ICI 2012 Letter, supra note 29. See also 
Gastineau March 2014 Letter, supra note 22, at 10, for a more 
detailed discussion of why the IIV would at best be a ``lagging 
indicator of actual portfolio values'' during times of rapid market 
movement.
    \34\ An IIV that is disseminated at more frequent intervals 
could present a different set of problems, as it may enable third 
parties to reverse engineer the underlying portfolio using data 
analysis. Therefore, changing the frequency of dissemination would 
not appear to be a viable option to the extent Applicants' objective 
is to prevent disclosure of the proposed ETF's portfolio. See also 
infra note 37 and accompanying text.
---------------------------------------------------------------------------

    24. The IIV is not subject to meaningful standards. Because there 
are no uniform methodology requirements, the IIV can be calculated in 
different ways rendering it potentially arbitrary and inconsistent.\35\ 
Also, Applicants acknowledge that no party has agreed to take 
responsibility for the accuracy of IIV calculation.\36\ Therefore, the 
Commission's preliminary conclusion is that the IIV calculation 
methodology is not appropriate for the IIV to be used as a primary 
pricing signal because it is potentially unreliable and susceptible to 
errors.\37\
---------------------------------------------------------------------------

    \35\ See, e.g., ICI 2012 Letter, supra note 29 (``[M]any parties 
participate in the calculation, publication, and dissemination of 
[IIV]. The ETF sponsor provides an independent calculation agent 
with the daily list of securities constituting an ETF's creation 
basket (which for U.S. equity ETFs is typically, but not always, a 
pro rata slice of the ETF's portfolio). The calculation agent 
separately obtains market pricing information for each of the 
component securities from a third party source, such as the exchange 
or a pricing vendor, and calculates the estimated per-share value of 
an ETF share. This process creates several opportunities for errors: 
for example, an ETF may report a basket inaccurately; a calculation 
agent may receive faulty data from a pricing vendor; or an error may 
be made in the calculation process. We understand that such errors 
are not infrequent.'' [emphasis added]).
    \36\ Applicants explicitly disclaim making any warranty by the 
ETFs as to the accuracy of the IIV. The Adviser would merely use 
``commercially reasonable efforts to assure that the calculation 
agent has an accurate listing of all securities in each [f]und's 
portfolio as of the beginning of trading on each day the [f]und is 
traded.'' Similarly, ``[a]lthough the calculation agent will not 
guarantee the accuracy of the IIV, the contract with the calculation 
agent will require that it use commercially reasonable efforts to 
calculate the IIV correctly. . . .'' Application at 31.
    \37\ As is the case with more frequent dissemination, an IIV 
that is sufficiently accurate and precise may also enable third 
parties to reverse engineer the underlying portfolio using data 
analysis. Such an ETF would thus once again become vulnerable to 
front running if its portfolio can be reverse engineered by others. 
See Gastineau March 2014 Letter, supra note 22, at 15.
---------------------------------------------------------------------------

    25. The IIV would be inaccurate for certain securities and asset 
classes. Because the IIV is constructed using last available market 
quotations or sale prices and not fair value prices for the underlying 
assets, it can be inaccurate.\38\ For example, as some securities do 
not trade frequently, the IIV would reflect the last quoted or sale 
price which could be stale and no longer reflect their current 
value.\39\ Other securities may not have yet opened for trading on a 
particular trading day or may be subject to an intraday interruption in 
trading.\40\
---------------------------------------------------------------------------

    \38\ See Hougan ETF Report, supra note 18. NAV includes fair 
value pricing, and with daily portfolio disclosure, market makers 
can estimate fair value on their own for the holdings of current 
ETFs.
    \39\ See, e.g., ICI 2012 Letter, supra note 29.
    \40\ See Gastineau March 2014 Letter, supra note 22 (noting that 
an exchange may institute a trading halt in a stock to address a 
significant order imbalance or in connection with release of 
important company news).
---------------------------------------------------------------------------

    26. Applicants note that up to 15% of the proposed ETFs' total 
assets could be in illiquid securities.\41\ Illiquid securities often 
fall within the category of securities for which there is no readily 
available market quotation and their fair value must be determined in 
good faith by the fund's directors.\42\ Therefore, a significant amount 
of illiquid securities in a proposed ETF's portfolio could exacerbate 
the deviation between the IIV and the NAV per share of the ETF because 
the accurate value of illiquid securities is determined by current fair 
valuation (reflected in the NAV) rather than use of stale pricing data 
(reflected in the IIV).\43\
---------------------------------------------------------------------------

    \41\ See 19b-4 Notice, supra note 13.
    \42\ 15 U.S.C. 80a-2(a)(41)(B). See also Independent Directors 
Council, Fundamentals for Newer Directors (Feb. 2014), available at 
http://fundamentals.idc.org/specific/specific_pricing, at 27.
    \43\ ETF sponsors seek to minimize exposure to assets that could 
impact this deviation because they can make arbitrage opportunities 
more difficult to evaluate. See Comment Letter of ICI, File No. S7-
07-08 (May 19, 2008). See also Comment Letter of The American Stock 
Exchange LLC, File No. S7-20-01 (Mar. 5, 2002) (``Ultimately it is 
in the interest of the sponsor and investment adviser to provide for 
effective arbitrage opportunities. It is unlikely that an . . . ETF 
sponsor would be able to convince the critical market participants 
such as specialists, market makers, arbitragers and other Authorized 
Participants to support a product that contained illiquid securities 
to a degree that would affect the liquidity of the ETF, making it 
difficult to price, trade and hedge, ultimately leading to its 
failure in the marketplace.'').
---------------------------------------------------------------------------

    27. Additionally, the proposed ETFs may invest a portion of their 
assets (up to a third of the total assets) in derivatives and foreign 
securities.\44\ Thinly traded derivatives contracts may lack readily 
observable market prices that could be used to update the IIV in real 
time. Similarly, because international securities are often traded 
outside the ETF's regular trading hours, their last available market 
prices could be up to a day old and no longer reflect their current 
value.\45\ Therefore, to the extent pricing inputs are unavailable or 
become stale for these alternative asset classes, the IIV would no 
longer be an accurate reflection of the NAV per share of the ETF.
---------------------------------------------------------------------------

    \44\ See 19b-4 Notice, supra note 13.
    \45\ See, e.g., ICI 2012 Letter, supra note 29; Ari I. Weinberg, 
An Extra Data Point on ETFs* (Aug. 4, 2013), available at http://online.wsj.com/news/articles/SB10001424127887323993804578611773169627276 (further noting that 
``[i]nternational markets also observe different holidays, meaning 
that a stock might not trade for several days even while an ETF that 
holds it is trading in the U.S.--leaving even more time for events 
that could result in a significantly different price when the stock 
starts trading again.'').
---------------------------------------------------------------------------

    28. IIV inaccuracies can increase ETF tracking errors. Errors in 
the IIV will likely lead to errors in estimating the factors that a 
market maker must consider when valuing a proposed ETF and constructing 
a hedging portfolio.\46\ Therefore, market makers may not be able to 
construct accurate hedging portfolios for the ETF shares.\47\ This 
would increase the tracking error associated with the hedging 
portfolios described above. As a result, tracking

[[Page 63969]]

errors between intraday ETF prices and NAV per share of the proposed 
ETF would also likely increase because greater tracking errors in 
hedging portfolios would expose the market maker's position to greater 
risk.\48\
---------------------------------------------------------------------------

    \46\ Such factors would include the market, asset class, sector 
and other risk factors. Market makers would need to estimate these 
exposures for a proposed ETF in order to construct hedging 
portfolios.
    \47\ This calls into question the reinforcement learning process 
which may not perform adequately during periods of heightened market 
volatility. See Sanmay Das, Intelligent Market-Making in Artificial 
Financial Markets, Massachusetts Institute of Technology--Artificial 
Intelligence Laboratory, AI Technical Report 2003-005, at 37.
    \48\ A commonly accepted assumption in economic models of market 
making is that market makers' bid-ask spreads compensate them for a 
number of costs including the risk they bear in their positions. See 
Maureen O'Hara, Market Microstructure Theory, First Edition (1998), 
at 35. Therefore, greater tracking errors in hedging portfolios for 
the proposed ETFs will likely result in higher bid-ask spreads and 
greater tracking errors between intraday ETF prices and the NAV of 
the ETF.
---------------------------------------------------------------------------

    29. In addition, it may be more difficult for market makers to 
construct appropriate hedging portfolios from the IIV for proposed ETFs 
with higher portfolio turnover. In particular, changing portfolio 
allocations can cause the factors that a market maker must consider 
when valuing a proposed ETF and constructing a hedging portfolio to 
fluctuate more rapidly. This would in turn increase uncertainty around 
the market maker's estimates of these factors.\49\ Therefore, proposed 
ETFs with more complex investment strategies involving dynamic factors 
will likely have higher tracking errors and bid-ask spreads if there is 
lack of sufficient information for market participants to construct 
tight hedges.\50\
---------------------------------------------------------------------------

    \49\ In contrast, turnover would introduce no such uncertainty 
in ETFs with daily portfolio disclosure as the end-of-day NAV would 
be marked to the previously disclosed portfolio, which is known by 
market makers.
    \50\ Applicants are seeking relief to launch, among others, 
long/short equity proposed ETFs. These types of funds have a higher 
portfolio turnover on average than that of actively managed equity 
funds. See Jing-Zhi Huang and Ying Wang, Should Investors Invest in 
Hedge Fund-Like Mutual Funds? Evidence from the 2007 Financial 
Crisis, 22 J. of Financial Intermediation 482 (2013), available at 
http://dx.doi.org/10.1016/j.jfi.2012.11.004, at 486-487 (finding 
that average turnover across 130/30 equity mutual funds was 196% 
from June 2003 until December 2009 versus less than 70% across all 
actively managed mutual funds in a comparable time period). These 
proposed ETFs also could have more thinly traded securities that 
could be more susceptible to price volatility during stressed market 
conditions. Therefore, it may be difficult for market makers to 
construct appropriate hedging portfolios from the IIV, making the 
proposed ETFs also likely to have higher tracking errors and bid-ask 
spreads.
---------------------------------------------------------------------------

    30. IIV inaccuracies can increase during periods of market stress 
or volatility. Market stress can reduce liquidity in certain assets and 
consequently increase errors in IIV as the portfolio becomes 
increasingly illiquid and current market prices become more difficult 
to determine. In addition, volatility can increase errors around prices 
used in IIV calculations as volatility can increase the movement of 
prices.
    31. In stressed markets, confidence in the pricing of (and in turn, 
the knowledge of) the ETF portfolio becomes increasingly important for 
market makers to continue to quote prices in ETF shares.\51\ By itself, 
the IIV of a proposed ETF likely will not instill such confidence in a 
proposed ETF's pricing because, as discussed above, the IIV is 
potentially unreliable and susceptible to errors.\52\ Nevertheless, a 
market maker that questions the current market price or IIV for an ETF 
can check those numbers against the NAV per share of the ETF output 
from its proprietary algorithm if the ETF has a fully transparent 
portfolio. That same market maker, however, would not be able to run a 
similar cross-check on those figures against a non-transparent ETF like 
the ones proposed by Applicants. Due to the inherent weaknesses of the 
IIV as a stand-alone metric, Applicants' proposal (which relies heavily 
upon the IIV as a substitute for full portfolio transparency) likely 
will not offer enough information about the underlying portfolio. As 
discussed below, this, in turn, likely would discourage market makers 
from making markets that would keep the market price for the proposed 
ETF's shares at or close to the NAV per share of the ETF, particularly 
under stressed market conditions when the need for real-time and 
verifiable pricing information becomes more acute.\53\
---------------------------------------------------------------------------

    \51\ See, e.g., Report to the Joint Advisory Committee on 
Emerging Regulatory Issues, Staffs of the CFTC and SEC (Sept. 20, 
2010) (``Flash Crash Report''), at 4-6 (noting that buy-side and 
sell-side interest returned only after market makers were able to 
verify the integrity of their data and systems and that they had to 
assess the risks of continuing to trade during the events of May 6, 
2010).
    \52\ See supra notes 28-37 and accompanying text.
    \53\ See infra Section V.
---------------------------------------------------------------------------

    32. Accordingly, the Commission's preliminary conclusion is that 
use of the IIV as a primary pricing signal for market making in 
Applicants' proposed ETFs would not result in an effective arbitrage 
mechanism.

B. Quarterly Release of Portfolio Holdings

    33. Applicants also propose providing their portfolio holdings 
disclosures on a quarterly basis, with a lag of not more than 60 days. 
But such disclosures would quickly lose their relevance for purposes of 
valuing or hedging the proposed ETFs because the content of their 
portfolios can change on a daily basis. This problem is heightened for 
ETFs with active management strategies that involve high portfolio 
turnover and alternative asset classes.\54\ Again, this may discourage 
market makers from making markets that would keep the market price for 
the proposed ETF's shares at or close to the NAV per share of the ETF, 
particularly during times of market stress when the need for real-time 
pricing information becomes more acute.
---------------------------------------------------------------------------

    \54\ Antti Petajisto, Active Share and Mutual Fund Performance, 
69 Financial Analysts Journal 73 (2013), available at http://www.cfapubs.org/doi/pdf/10.2469/faj.v69.n4.7, at 83. The study found 
that annual turnover across U.S. all-equity mutual funds is 87%. As 
a result, approximately 14% of the portfolio changes over the 60 
days following the portfolio disclosure (prorating annual turnover 
of 87% for 60 days) and an additional 22% of the portfolio changes 
over the course of the following quarter (prorating annual turnover 
of 87% for three months). Therefore, there may be significant 
tracking errors between an ETF's current portfolio holdings and its 
prior quarterly portfolio disclosure.
---------------------------------------------------------------------------

C. Back-Up Redemption Option

    34. In light of concerns about the effect on retail investors if 
the arbitrage mechanism failed to keep market prices at or close to the 
NAV of the proposed ETFs, Applicants proposed a redemption option that, 
in their view, would act as a ``fail-safe'' mechanism in the event of a 
persistent and significant deviation of closing market price from NAV. 
For the reasons discussed below, the Commission preliminarily believes 
that this redemption option does not remedy the defects with 
Applicants' proposal outlined above such that exemptive relief would be 
appropriate.
    35. Under the proposal, retail investors exercising the redemption 
option would be subject to redemption and brokerage fees, which would 
likely discourage use of the option. Specifically, retail investors 
exercising the redemption option would be subject to a redemption fee 
of up to 2% of the value of shares redeemed. In addition, retail 
investors would likely be charged additional brokerage commissions to 
exercise the option. These fees and costs may dissuade retail investors 
from exercising a redemption option meant to provide retail investors 
with the ability to transact with the ETF on an equal footing with the 
Authorized Participants.\55\
---------------------------------------------------------------------------

    \55\ An economically rational investor who seeks to exercise the 
option is likely not to redeem until a trading discount to IIV in 
the secondary market exceeds the costs to redeem (i.e., the 
redemption fee plus the brokerage charges). Given that typical bid/
ask spreads for ETFs with underlying diversified domestic equity 
holdings average 4 basis points, a redemption fee set at 2% will 
cost the investor 200 basis points (not including brokerage charges) 
to exit the proposed ETFs. See Antti Petajisto, Inefficiencies in 
the Pricing of Exchange-Traded Funds (Sept. 20, 2013), available at 
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000336 
(``Petajisto ETF Study''), at Table III. This assumes that the 
investor has the information necessary (IIV, bid price for the 
shares, redemption fee, brokerage charges) to make the determination 
of whether to redeem directly from the proposed ETFs or sell on the 
market. See generally, Matt Hougan, The Flaws in the iNAV, Exchange-
Traded Funds Report (July 2009), at 5 (noting that investors would 
have to have deep quantitative experience to create models to see if 
they were getting fair prices on ETF trades today); and John 
Beshears, James Choi, David Laibson, and Brigitte C. Madrian, How 
Does Simplified Disclosure Affect Individuals' Mutual Fund Choices?, 
in Explorations in the Economics of Aging, edited by David A. Wise 
(2011) (noting that many retail investors lack the ability to 
perform even elementary calculations to compare investment options 
with differing sales fees).

---------------------------------------------------------------------------

[[Page 63970]]

    36. Moreover, the proposed redemption option is also problematic 
because it would become available to investors only after ETF shares 
have persistently been trading at a discount of at least 5% from NAV 
for 10 consecutive business days. This would result in disparate 
treatment of investors compared to Authorized Participants and would 
further restrict investors' ability to transact at prices at or near 
NAV. The Commission is concerned that forcing investors to remain 
invested in a product that is trading at a significant discount to NAV 
per share for two weeks before the redemption option is available may 
lead to significant investor harm in the interim.\56\ Investors would 
not be able to exit or would have to exit at a price substantially 
below the NAV per share of the ETF, which would be contrary to the 
foundational principle underlying section 22(d) and rule 22c-1 under 
the Act that all shareholders be treated equitably when buying and 
selling their fund shares.\57\ In the meantime, Authorized Participants 
would have the advantage of transacting directly with the ETF on a 
daily basis at NAV.
---------------------------------------------------------------------------

    \56\ See, e.g., Petajisto ETF Study, supra note 55, at 18 
(generally discussing economic magnitude of mispricings).
    \57\ See supra note 5 and accompanying text.
---------------------------------------------------------------------------

    37. But even if Applicants were able to address the Commission's 
concerns about the retail redemption option, this would not address the 
Commission's more fundamental concerns about Applicants' proposal. As 
discussed above, Applicants are proposing an ETF model that the 
Commission 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. The presence of a back-up retail redemption option does not cure 
the inherently flawed structure of the proposed ETFs here.\58\
---------------------------------------------------------------------------

    \58\ Applicants proposed the redemption option described above 
in response to the staff's suggestion. The Commission preliminarily 
believes that the inherent structural flaw of the proposed ETFs--
i.e., the potential lack of an effective arbitrage mechanism--cannot 
be solved by the proposed fail-safe mechanism.
---------------------------------------------------------------------------

V. The Commission's Preliminary View

    38. As discussed above, the Commission preliminarily believes that 
Applicants have not provided an adequate substitute for portfolio 
transparency such that the proposed ETFs would consistently trade at or 
close to NAV. A close tie between market price and NAV per share of the 
ETF is the foundation for why the prices at which retail investors buy 
and sell ETF shares are similar to the prices at which Authorized 
Participants are able to buy and redeem shares directly from the ETF at 
NAV. This close tie between the prices paid by retail investors and 
Authorized Participants is important because section 22(d) and rule 
22c-1 under the Act are designed to require that all fund shareholders 
be treated equitably when buying and selling their fund shares.\59\ In 
fact, in granting relief from section 22(d) and rule 22c-1 under the 
Act, the Commission has relied on this close tie between what retail 
investors pay and what Authorized Participants pay to make the finding 
that the ETF's shareholders are being treated equitably when buying and 
selling shares.
---------------------------------------------------------------------------

    \59\ See supra note 5.
---------------------------------------------------------------------------

    39. The lack of portfolio transparency or an adequate substitute 
for portfolio transparency coupled with a potentially deficient back-up 
mechanism presents a significant risk that the market prices of ETF 
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. This would be contrary to the 
foundational principle underlying section 22(d) and rule 22c-1 under 
the Act--that shareholders be treated equitably--and may, in turn, 
inflict substantial costs on investors, disrupt orderly trading and 
damage market confidence in secondary trading of ETFs.

A. Substantial Costs to Investors

    40. One of the primary benefits of current ETFs is that investors 
are generally able to obtain a similar economic experience to investors 
in traditional open-end funds (i.e., price at or close to NAV), but 
without certain of the costs associated with such funds (e.g., transfer 
agency fees). The Commission preliminarily believes the proposed ETFs 
would not provide either element of this benefit if, as the Commission 
anticipates, the arbitrage mechanism does not function properly. A 
breakdown in the arbitrage mechanism could result in material 
deviations between market price and NAV per share of the ETF. Such 
deviations can hurt an investor. For example, if an investor places a 
buy order and the ETF is trading at a premium, this would result in a 
lower return for the investor as opposed to if the investor had bought 
the ETF when its prices were at or close to the NAV per share of the 
ETF or at a discount. As discussed above, the arbitrage mechanism 
inherent in the ETF structure keeps these differences small.
    41. In this regard, the Commission finds it significant that market 
makers for Applicants expressed some skepticism during meetings with 
Commission staff that the IIV could be used as the primary pricing 
signal for ETFs with active management strategies that might involve 
high portfolio turnover or alternative asset classes.\60\ They 
indicated that they would likely use the pieces of information provided 
by the Applicants (IIV, quarterly portfolio holdings disclosure and 
prospectus disclosure) to construct hedge portfolios using 
sophisticated algorithms.\61\ Their ability to construct hedge 
portfolios that are generally predictive of the portfolio holdings of 
the ETF is critical to their management of their exposure to the ETF. 
If there is a break in the alignment between the market makers' hedge 
portfolios and the NAV per share of the ETF, the market makers' risk of 
loss increases. The greater the risk of loss, the more the market 
makers will seek to cover that risk by quoting wider price spreads of 
the proposed ETFs. This would result in market prices, at which 
investors would buy and sell the ETF shares, not being at or close to 
the NAV per share of the ETF, which would be contrary to the 
foundational principle underlying section 22(d) and rule 22c-1 under 
the Act that shareholders be treated equitably.
---------------------------------------------------------------------------

    \60\ Commission staff met with market makers invited by the 
Applicants on January 23, 2014.
    \61\ ETF market makers commonly use representative hedging 
portfolios instead of trading in basket securities because they may 
be easier to implement or more cost effective. They do this to 
offset market exposures as they build short or long positions in the 
ETFs intraday. The market maker will earn profits to the extent its 
hedge portfolio deviates from the NAV per share. See Gastineau March 
2014 Letter, supra note 22, at 6.
---------------------------------------------------------------------------

    42. The Commission preliminarily believes that, even under normal 
market conditions, market makers could be unable to deconstruct the 
portfolio holdings of a proposed ETF with sufficient accuracy in order 
to construct a hedge portfolio that is closely aligned to the NAV per 
share of the ETF. The proposed disclosures by the Applicants would 
likely be useful in narrowing down the pool of securities and other

[[Page 63971]]

assets that may be held by the ETF, but only to a limited extent. For 
example, prospectus disclosures of general risks and investment 
objectives provide little quantitative precision about an ETF's assets 
and risk exposures. The proposed quarterly portfolio disclosures would 
provide little additional quantitative precision as a result of 
portfolio turnover, as discussed previously. Consequently, variability 
would inevitably be introduced into the proposed model. The Commission 
believes that this may lead to a break in alignment between a market 
maker's hedge portfolio and the NAV per share of the ETF; this could 
diminish the market maker's ability to manage its risks, which, in 
turn, could increase its risk of loss.\62\ This greater risk of loss 
would be reflected in wider bid/ask spreads and result in intraday 
market prices that deviate from the NAV per share of the ETF, which 
would be contrary to the foundational principle underlying section 
22(d) and rule 22c-1 under the Act that shareholders be treated 
equitably.
---------------------------------------------------------------------------

    \62\ See Examining the Exchange-Traded Nature of Exchange-Traded 
Funds, Morningstar ETF Research (Feb. 11, 2013) (``Morningstar ETF 
Report''), at 21 (``To consider conducting an arbitrage transaction, 
arbitrageurs must be fairly confident that they will receive a 
return commensurate with the level of risk they are assuming. 
Therefore, it is likely that intraday changes to volatility (that 
is, risk) cause arbitrageurs to become more or less confident when 
transacting in the equity market for purposes of arbitrage and thus 
cause premiums or discounts to occur in the short term. . . . From 
the perspective of an arbitrageur, increased equity market 
volatility implies that the value of purchased equities relative to 
the value of the ETF's shares is at greater risk to fall and thus 
increases the potential that arbitrage trade will be less 
profitable, if at all. Therefore, when equity market volatility 
rises, it is likely that an arbitrageur would wait longer before 
acting to exploit an ETF premium. As a result, the ETF market price 
would outperform the NAV price on days when equity market volatility 
is increasing. . . . Arbitrageurs knowingly leave profits on the 
table for a short amount of time because the risk or cost to trade 
and profit is too high at that time.'').
---------------------------------------------------------------------------

    43. The Commission also preliminarily believes that this potential 
price disparity could be even worse under times of market stress or 
volatility. Market makers would likely be heavily reliant on 
sophisticated algorithms to deconstruct the portfolio holdings of the 
proposed ETF in order to construct the hedge portfolio. During times of 
market stress or volatility, the Commission believes that reliance on 
these algorithms would not be sufficient for market making purposes in 
the proposed ETFs and the correspondence between the hedge portfolio 
and the NAV per share of the ETF might be expected to lag. This is 
because the market makers' hedge portfolio may deviate significantly 
from the actual portfolio of the proposed ETF, resulting in greater 
intraday market risk to the market maker and a corresponding widening 
of the bid/ask spread.\63\ This would result in market prices, at which 
investors would buy and sell the ETF shares, not being at or close to 
the NAV per share of the ETF, which would be contrary to the 
foundational principle underlying section 22(d) and rule 22c-1 under 
the Act that shareholders be treated equitably. Accordingly, although 
some market makers supporting Applicants noted that they should be able 
to construct hedge portfolios that were closely aligned (and would 
remain aligned) to the NAV per share of the ETF for the domestic equity 
ETFs proposed by Applicants, the Commission cannot fully agree with 
that conclusion.
---------------------------------------------------------------------------

    \63\ Ron Delegge, ETF Bid/Ask Spreads (Apr. 23, 2013), available 
at http://investius.com/2013/04/23/etf-bidask-spreads/.
---------------------------------------------------------------------------

    44. Finally, although Applicants proposed a retail redemption 
option to address a significant and persistent deviation of market 
price to NAV, as discussed in detail above, the Commission 
preliminarily believes that this option is not sufficient to protect 
investors as required by the Act.

B. Potential Disruption of Orderly Trading and Damage to Market 
Confidence

    45. In the absence of sufficient information for market makers to 
accurately assess the value of the underlying portfolio securities and 
to make markets in ETF shares at levels that are closely aligned to the 
NAV per share of the ETF, market makers are likely to trade in proposed 
ETFs with wide bid/ask spreads and variable premiums/discounts to the 
NAV per share of the ETF. This would be particularly the case during 
times of market stress and for active management strategies that might 
involve high portfolio turnover when there is a greater need for 
confidence in pricing signals.\64\ Under particularly stressful or 
volatile market conditions, the inability to independently and 
accurately value an ETF's portfolio assets may cause market makers to 
withdraw from providing meaningful liquidity, which in turn can lead to 
the disruption of orderly trading in the ETF.\65\ The Commission 
preliminarily believes that a structure that may lead market makers to 
make markets in the proposed ETFs at prices that are not closely 
aligned to the NAV per share of the ETF is not necessary or appropriate 
in the public interest, nor is it consistent with the protection of 
investors or with the foundational principle underlying section 22(d) 
and rule 22c-1 under the Act that shareholders be treated equitably.
---------------------------------------------------------------------------

    \64\ See supra note 50 and accompanying text.
    \65\ See Flash Crash Report, supra note 51, at 4-6. See also 
Morningstar ETF Report, supra note 62.
---------------------------------------------------------------------------

    46. Further, any breakdown in the pricing or the ability to price 
the proposed ETF may result in damage to market confidence in secondary 
trading of ETFs--not just in the proposed product, but in ETFs 
generally. Investors may exit the ETF market because of a loss of 
trust, particularly in actively managed ETFs, should the proposed ETFs 
fail to function in a manner similar to current ETFs.\66\ For this 
additional reason, the Commission preliminarily believes that it is not 
necessary or appropriate, nor in the public interest or consistent with 
the protection of investors and the purposes fairly intended by the 
policy and provisions of the Act, to grant the requested relief.
---------------------------------------------------------------------------

    \66\ See Tamar Frankel, Regulation and Investors' Trust in the 
Securities Markets, 68 Brook. L. Rev. 439 (2002), at 448 (arguing 
that once investors' trust is lost, they will flee the stock markets 
and turn to other types of investments that ``they can see, evaluate 
and guard for themselves.'').
---------------------------------------------------------------------------

* * * * *
    47. In light of the foregoing, the Commission remains unconvinced 
that Applicants' proposed ETFs meet the standard for relief under 
section 6(c) of the Act. Accordingly, absent a request for a hearing 
that is granted by the Commission, the Commission intends to deny 
Applicants' request for an exemption under section 6(c) of the Act as 
not necessary or appropriate in the public interest and as not 
consistent with the protection of investors and the purposes fairly 
intended by the policy and provisions of the Act.

    By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-25438 Filed 10-24-14; 8:45 am]
BILLING CODE 8011-01-P


