Nearly three years after the U.S. Securities and Exchange Commission ("SEC") effectively froze the creation of actively managed and leveraged exchange traded funds ("ETFs") that utilize options, futures, swaps, and other derivatives as part of their investment strategies, the SEC has lifted the moratorium on the use of derivatives by actively managed funds while continuing to restrict the use of derivatives by leveraged ETFs. The SEC's decision follows a Concept Release issued last August soliciting comments on the issue from the public. ETFs, which are typically registered as open-ended investment companies under the Investment Company Act of 1940 (the "'40 Act"), usually require exemptive relief from the SEC because certain common features of ETFs do not comport with the strict provisions of the '40 Act.

On December 6, 2012, in a speech to the American Law Institute's Conference on Investment Adviser Regulation in New York City, Norm Champ, Director of the Division of Investment Management, announced the SEC has reversed course and "will no longer defer consideration of exemptive requests under the Investment Company Act relating to actively managed ETFs that make use of derivatives." In his speech, Director Champ made clear the SEC's decision was subject to two important conditions, each designed to address the concerns by the SEC back in March 2010 when it first imposed the moratorium on derivatives. To that end, issuers seeking to create an actively managed ETF that employs derivatives will be required to represent: "(i) that the ETF's board periodically will review and approve the ETF's use of derivatives and how the ETF's investment adviser assesses and manages risk with respect to the ETF's use of derivatives; and (ii) that the ETF's disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant Commission and staff guidance."

Importantly, however, the SEC is lifting only its moratorium on the use of derivatives by actively managed ETFs. Actively managed ETFs are similar to mutual funds in that they rely on an investment manager to select investments rather than tracking a market index or other benchmark like a traditional ETF. They represent a small but fast-growing segment of the ETF market, and numerous ETF issuers are reportedly poised to take advantage of the SEC's policy change. In addition, the SEC's action could make it more appealing for traditional mutual fund companies to enter the ETF market, generating additional market share for—and competition within—the actively managed ETF space. Nonetheless, the exchanges in which actively managed ETFs are listed and trade must file Form 19b-4 for each ETF that uses derivatives with the SEC's Division of Market Regulation and obtain the approval of the SEC prior to trading shares of such actively managed ETFs. These applications can be subject to delay in approving such applications.

The SEC still intends to effectively prohibit the creation of leveraged ETFs that use derivatives. The continuing prohibition on derivative use by leveraged ETFs, which generally seek to deliver multiples of the daily performance of the index or benchmark they track, accords with the SEC and other regulators' heightened scrutiny in recent years of more complex and exotic exchange traded products. The SEC's decision to differentiate between actively managed and leveraged ETFs in this case suggests that this scrutiny will continue.

A copy of Director Champ's December 6, 2012 speech is posted here.

A copy of the Commission's March 25, 2010 Notice on the use of derivatives is posted here.

A copy of the Commissions August 31, 2011 Concept Release is posted here.