On November 6, 2014, the Securities and Exchange Commission (SEC) issued a notice related to an exemptive order application that would permit the offering of exchange-traded managed funds (ETMFs), a new kind of registered investment company that is a hybrid between a traditional mutual fund and an exchange-traded fund (ETF). An ETMF’s hybrid structure is designed to provide to investors certain cost and tax efficiencies of ETFs while maintaining the confidentiality of current portfolio securities.

ETMFs are like ETFs in that they would:

  • List and trade on a national securities exchange (Listing Exchange)
  • Directly issue and redeem shares in large aggregations only (Creation Units)
  • Impose fees on Creation Units issued and redeemed to a party (Authorized Participant) that has entered into a participant agreement with the ETMF’s distributor with respect to the creation and redemption of Creation Units to offset the related costs to the ETMFs
  • Primarily utilize in-kind transfers of portfolio securities in issuing and redeeming Creation Units (Basket Instruments or Baskets)

Like mutual funds, ETMFs would:

  • Be bought and sold at prices linked to net asset value (NAV)
  • Seek to maintain the confidentiality of their current portfolio securities

Exchange Trading & NAV-Based Trading

ETMF shares would trade throughout the day at NAV plus or minus a premium/discount that may vary during the trading day. This premium/discount would be quoted by one or more member firms of the Listing Exchange that will act as market maker (Market Maker) and maintain a market for the ETMF shares trading on the Listing Exchange. Although share prices would be quoted throughout the trading day relative to NAV, there would not be a fixed relationship between share trading prices and an ETMF’s NAV. For each trade, the premium/discount (which may be zero) would be locked in at trade execution, and the final transaction price (i.e., NAV plus or minus the premium/discount) would be determined at the end of the business day when the ETMF’s NAV is calculated.

Accordingly, unlike ETFs, NAV-based trading would not offer investors the opportunity to transact intraday at prices based on current (versus end-of-day) determinations of the shares’ value. Instead, like intraday orders to buy or sell shares of mutual funds, an ETMF investor would not know the NAV at the time the order is placed, but the levels of premium/discount would be fully transparent, allowing investors to see the execution costs of buying or selling shares. Market Makers and other dealers, in turn, would compete for transactions in shares at a profitable premium/discount level.

Lack of Portfolio Transparency

The SEC determined that, in light of NAV-based trading, daily portfolio transparency is not necessary for ETMFs. Contemporaneous portfolio holdings disclosure has been viewed as necessary for effective arbitrage and efficient secondary market trading of ETFs. In ETF trading, tight bid-ask spreads and narrow premiums/discounts cannot be assured unless Market Makers have sufficient knowledge of portfolio holdings to enable them to effectively arbitrage differences between an ETF’s market price and its underlying portfolio value and to hedge the intraday market risk they assume as they take inventory positions in connection with their market-making activities. In NAV-based trading, Market Makers do not engage in arbitrage and assume no intraday market risk in their share inventory positions because all trading prices are linked to NAV.

Because there is no intraday market risk, there is no need for Market Makers to engage in intraday hedging activity, and, therefore, there should not be any associated requirement for current portfolio holdings disclosure to maintain a tight relationship between share trading prices and NAV.

Creations & Redemptions

The SEC’s concerns stated in its recent denial of the active “non-transparent” ETF structure proposed by Precidian Funds LLC are not applicable to the ETMF structure because each ETMF would process purchases and redemptions of Creation Units in a manner that would protect the ETMF from any investor who might seek advantageous treatment vis-à-vis other investors. In most circumstances, the names and quantities of the instruments that constitute the Basket Instruments on a given business day would be identical for all purchasers and redeemers of an ETMF’s Creation Units that day.

To preserve the confidentiality of an ETMF’s trading activities, the Basket would normally not be a pro rata slice of the portfolio securities. Instruments being acquired by the ETMF would generally be excluded from the Basket until their purchase is completed and Basket Instruments being sold may not be removed from the Basket until the sale program is substantially completed. Further, other portfolio securities would be excluded from the Basket when the adviser deems it to be in the best interests of an ETMF and its shareholders.

Novel Relief

The exemptive relief requested from the SEC is the same relief the SEC has previously granted to permit the operation of ETFs, except ETMFs also require exemptive relief under Section 22(d) and Rule 22c-1 under the Investment Company Act of 1940 (Act) with respect to NAV-based trading. ETMF trading prices would be directly tied to NAV. Unlike ETFs, ETMFs need relief under these sections of the Act because their trading prices deviate from NAV with respect to the execution costs of buying and selling ETMF shares (i.e., the premium/discount). In contrast, ETFs need relief because of differences related to the value of the underlying portfolio positions. Therefore, because ETMF shares’ trading prices are directly tied to NAV, an arbitrage mechanism that would keep market price close to or at NAV is not necessary.

Section 22(d) of the Act, among other things, prohibits a dealer from selling a redeemable security that is currently being offered to the public by or through a principal 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 prevent dilution caused by riskless trading schemes, require that shareholders are treated equitably when buying and selling fund shares, and assure an orderly distribution system of investment company shares. None of these purposes would be thwarted by permitting NAV-based share trading because it would not dilute the shareholders’ beneficial interests in ETMFs because secondary market trading in shares would not involve the ETMF’s portfolio. Further, NAV-based trading responds to concerns of unjust price discrimination among purchasers and preserving an orderly distribution of shares because they would trade on an exchange, a regulated venue, at market-determined premiums/discounts, and the current and historical premiums/discounts also would be transparent to investors and intermediaries.