The SEC has given a preliminary thumbs-down to non-transparent exchange traded funds (ETFs). In two separate notices issued on October 21, 2014, (found here and here), the Commission stated that applications to allow actively managed ETFs to withhold daily disclosure of portfolio holdings did not “meet the standard for exemptive relief” under Section 6(c) of the Investment Company Act of 1940. Accordingly, the Commission took the unusual step of preliminarily denying the applications.

The Reasons for ETF Transparency

ETFs – typically structured as open-end investment companies – can only function with an SEC order that exempts them from rules that would otherwise make it impossible for them to operate. One reason is that open-end funds must redeem their shares based on investor demands at the current net asset value. For this reason, shares of open-end funds are not traded on exchanges. For ETFs to trade their shares on securities exchanges, they must obtain an exemption from several rules, including the requirement that investment companies redeem their shares at the current NAV.

ETFs typically sell shares in large “wholesale” lots called “creation units” to “authorized participants,” who in turn allow those shares to be traded on an exchange. Similarly, the ETFs redeem shares only from the authorized participants in “redemption units.” In creating this alternative mechanism for buying and selling shares, the SEC imposes conditions to ensure that shares trade on exchanges at close to their actual net asset value. Authorized Participants typically buy creation units by contributing like securities, which may be combined with cash. To ensure that the market and NAV prices are similar, the SEC requires, among other things, daily portfolio transparency. That is, if investors know what is in the ETF’s portfolio, the extent of any discount or a premium in market trades is minimized.

The Two Current Proposals

At least two ETF sponsors proposed to create actively-managed ETFs that would not follow the universal practice of disclosing their portfolio holdings on a daily basis. The proposed ETFs would publish an intraday indicative value (IIV), which is an approximation of the ETF’s NAV. The IIV, published every 15 seconds, would be a way to minimize discounts and premiums.

The reason for the proposals was that the sponsors of the proposed ETFs do not want to disclose their portfolio holdings. Accordingly, they proposed an alternative mechanism involving a “blind trust” for each authorized participant. The proposals would allow retail investors (but not institutional investors) an alternative “back-up redemption option” that would allow them to redeem their shares directly from the ETF, rather than selling them on an open market, in the event of a significant deviation of the closing market price from the NAV. Retail shareholders using this option would be subject to a redemption fee of up to two percent. 

The SEC’s Preliminary Denial

In preliminarily denying the proposals, the SEC said that the proposed structure, combined with enhanced prospectus disclosure, “falls short of providing a suitable alternative to the arbitrage activity in ETF shares that is critical to helping keep the market price of current ETF shares at or close to the NAV per share of the ETF.” 

Among other things, the SEC said that even dissemination of the IIV every 15 seconds is inadequate for purposes of making efficient markets, and “could result in poor execution.” Moreover, the SEC cited lack of meaningful standards for IIV methodologies, and a lack of accountability for responsibility to ensure the accuracy of IIV calculations. The SEC cited other issues with the reliability of the IIV, including tracking errors and inaccuracies during periods of market stress.

The SEC also had issues with the proposed frequency of portfolio reporting. It said that a “back-up redemption option,” which would allow retail investors to redeem shares at the current day-end NAV under certain conditions and with the payment of a fee, “does not remedy the defects” with the proposal. The SEC said it believed that the lack of sufficient information about the portfolio could result in potential disruption of orderly trading and to market confidence.

Is the idea of a non-transparent ETF dead? The SEC said that the applicants could request a hearing to argue their case and overcome the SEC’s carefully explained objections to the proposed ETFs. In the absence of a request for a hearing, the SEC will deny the applications. It seems likely that, at least for now, the SEC considers non-transparent ETFs not ready for prime time.