Barely two weeks after it signaled thumbs-down on two requests to approve non-transparent exchange-traded funds (ETFs), the SEC on November 6, 2014 published a notice of application that would allow the applicant to create “exchange-traded mutual funds,” or ETMFs, a novel structure that is a hybrid between mutual funds and traditional ETFs.
ETMFs feature characteristics of ETFs and traditional mutual funds. Like ETFs, ETMFs would list and trade on a national securities exchange; directly issue and redeem shares only in “creation units,” impose fees on creation units issued and redeemed to Authorized Participants to offset costs; and primarily use in-kind transfers of securities when issuing and redeeming creation units. Like mutual funds, ETMFs would sell and redeem their shares at prices linked to the funds’ net asset value (NAV) and would maintain confidentiality of current portfolio positions.
ETMF shares would trade on an exchange at the next-determined NAV, plus or minus any premium or discount quoted by market makers. The premium or discount would be based on market factors, including the balance of supply and demand for shares, share inventory positions, and volume. Investors would lock in the premium or discount at the time of trade, but the actual transaction price would be based on the ETMF’s actual NAV determined as of the close of business. Thus, investors won’t know the NAV at the time they place an order, but the levels of premium and discount would be fully transparent.
Like ETFs, only Authorized Participants could buy and sell ETMF creation units, based on the next-determined NAV, with transactions effected in-kind through “baskets” of securities that are included in the portfolio. But the baskets will not necessarily mirror all the ETMF’s portfolio holdings. That is, to protect confidentiality of holdings, the baskets will not reflect portfolio positions that the ETMF is currently buying or selling. The portion of the basket attributable to the confidential holdings instead will consist of cash. The ETMF’s adviser will determine which portfolio positions to exclude from the basket based on what it believes to be in the best interest of the portfolio.
The purchase and redemption price of creation units will reflect transaction costs of the ETFMF. These costs include costs of clearance and settlement and trading costs.
Like ETFs, the ETMFs will arrange for third parties to publish an intraday indicative value (IIV) of the ETMF’s shares. But, unlike ETFs, the IIV would not provide pricing signals for market intermediaries that seek to estimate the difference between the current value of the ETMF’s holdings and the trading price. Because retail investors transact in shares at the next-determined NAV, intermediaries do not assume intraday market risk in their share inventories.
Why did the SEC reject non-transparent ETFs but does not seem concerned that ETMFs will keep their portfolio holdings confidential? In short, because ETMFs will trade shares based on the next-determined NAV, the market makers could not engage in arbitrage and will assume no intraday market risk in their inventory positions. No intraday risk, in turn, means that there would be no need for market makers to engage in intraday hedging activity, thus eliminating the need to know up-to-the-minute portfolio holdings.
If they are freed from the requirement to provide daily portfolio transparency, ETMFs can take advantage of cost and tax efficiencies with protections that ETF shareholders can realize.
The regulatory relief that the SEC will grant to ETMFs differs from ETF orders only with respect to Section 22(d) of the Investment Company Act of 1940 and related Rule 22c-1, concerning NAV-based trading. The difference in regulatory relief arises due to the portion of the trading price that is the negotiated amount of the premium or discount. In all other respects, the order for ETMFs will resemble orders issued to traditional ETFs.
The SEC set a deadline of December 1, 2014 for interested persons to request a hearing.