NYSE Arca, Inc. and BATS BZX Exchange, Inc. (each, an Exchange) separately received U.S. Securities and Exchange Commission (SEC) approval on July 22, 2016 to adopt generic listing standards for exchange-traded funds (ETFs) that are actively managed (Active ETFs).1 These generic listing standards (Listing Standards) will allow an Active ETF that meets the applicable requirements to list on an Exchange without specific approval from the SEC’s Division of Trading and Markets staff.
Previously, generic listing standards were available only for ETFs that seek to track the performance of a specific benchmark index (Passive ETFs), while Active ETFs could only be listed on an Exchange if they obtained an SEC order approving an Exchange rule change pursuant to Rule 19b-4 under the Securities Exchange Act of 1934 (Exchange Act). The Rule 19b-4 process takes several months to complete and thus introduces uncertainty to an Active ETF’s launch timeline. The Rule 19b-4 process also creates uncertainty with respect to an Active ETF’s product design, as the Division of Trading and Markets staff routinely imposes certain restrictions on an Active ETF’s investments in connection with consideration of a Rule 19b-4 filing. Now, Active ETFs that meet the Listing Standards will be able to list once the applicable Exchange makes only a notification to the SEC – thereby significantly reducing the Active ETF’s time to market and providing greater certainty in Active ETF product design. Active ETFs that cannot satisfy the Listing Standards will still be required to undergo the Rule 19b-4 filing process to seek specific approval from the Division of Trading and Markets staff, although several of the Listing Standards codify long-standing staff positions as to appropriate restrictions on an Active ETF’s investments.
The Listing Standards impose certain standards on portfolios of Active ETFs, which vary according to security or asset type. Many of the Listing Standards are modeled on and, in many instances, track the existing generic listing standards for Passive ETFs. The Listing Standards include requirements with respect to market capitalization, trading volume, portfolio component weighting and principal amount outstanding, as well as issuer diversification requirements. Notably, Active ETFs will be required to satisfy the Listing Standards both at the time of listing and on a continuous basis (i.e., not solely at the time of a portfolio investment decision).2 Consequently, Active ETF sponsors should consider their compliance system capabilities with respect to monitoring for compliance with the Listing Standards on a continuous basis. Importantly, the Listing Standards are in certain respects more restrictive than the terms of some Active ETFs’ Rule 19b-4 orders issued to date, and therefore Active ETF sponsors should still consider pursuing the Rule 19b-4 filing process in the event they want to bring a new Active ETF to market that does not fit within the Listing Standards.
With respect to the component stocks of the equity portion of an Active ETF portfolio, the Listing Standards require that:
- Component stocks accounting in the aggregate for at least 90% of the equity weight of the portfolio each must have a minimum market value of $75 million (at least 100% and $100 million for non-U.S. component stocks).
- Component stocks accounting in the aggregate for at least 70% of the equity weight of the portfolio each must have a minimum monthly trading volume of 250,000 shares or minimum notional volume traded per month of $25 million, averaged over the last six months (at least 100% and 250,000 shares or $25 million for non-U.S. component stocks).
- The most heavily weighted component stock may not exceed 30% of the equity weight of the portfolio and, to the extent applicable, the five most heavily weighted component stocks may not exceed 65% of the equity weight of the portfolio (25% and 60% for non-U.S. component stocks).
- The portfolio must have a minimum of 13 component stocks (20 for non-U.S. component stocks), subject to certain exceptions.3
- The component stocks are listed on a national securities exchange and must be NMS Stocks4(non-U.S. component stocks must be listed and traded on an exchange with last-sale reporting).
- American Depositary Receipts (ADRs) may be exchange-traded or non-exchange-traded, provided that no more than 10% of the equity weight of the portfolio may consist of non-exchange-traded ADRs.
The Listing Standards impose a limit of 25% of the equity weight of the portfolio with respect to investments in leveraged and/or inverse leveraged Derivative Securities Products or Index-Linked Securities/Linked Securities.5
The Listing Standards do not require that any portion of an Active ETF’s equity portfolio comprising non-U.S. equity securities be listed on a market that is either a member of the Intermarket Surveillance Group (ISG) or a market with which the Exchange has a comprehensive surveillance sharing agreement (CSSA), so long as such investments satisfy the portfolio standards summarized above. The absence of such a requirement should facilitate greatly the ability of ETF sponsors to launch non-U.S. equity focused Active ETFs.
Fixed Income Securities
With respect to the fixed income securities6 of an Active ETF portfolio, the Listing Standards require that:
- Component stocks accounting in the aggregate for at least 75% of the fixed income weight of the portfolio each must have a minimum original principal amount outstanding of $100 million or more.
- No component fixed income security (excluding Treasury Securities and GSE Securities) may represent more than 30% of the fixed income weight of the portfolio, and the five most heavily weighted component fixed income securities in the portfolio (excluding Treasury Securities and GSE Securities) may not in the aggregate account for more than 65% of the fixed income weight of the portfolio.
- The portfolio must have a minimum of 13 non-affiliated issuers, subject to certain exceptions.7
- At least 90% of the fixed income weight of the portfolio must be: (a) from issuers that are required to file reports pursuant to Sections 13 and 15(d) of the Exchange Act; (b) from issuers that have a worldwide market value of their outstanding common equity held by non-affiliates of $700 million or more; (c) from issuers that have outstanding securities that are notes, bonds, debentures, or evidence of indebtedness having a total remaining principal amount of at least $1 billion; (d) exempted securities as defined in Section 3(a)(12) of the Exchange Act; or (e) from issuers that are a government of a foreign country or a political subdivision of a foreign country.
- Non-agency, non-GSE and privately-issued mortgage-related and other asset-backed security components of a portfolio may not account, in the aggregate, for more than 20% of the weight of the fixed income portion of the portfolio.
The Listing Standards also provide that an Active ETF may invest without limitation in cash and cash equivalents, specifically short-term instruments8 with maturities of less than three months.
The Listing Standards permit, without limitation, an Active ETF to invest in listed derivatives, subject to the following requirements:
- In the aggregate, at least 90% of the weight of the Active ETF’s holdings of futures, exchange-traded options and listed swaps that are centrally cleared (calculated as the aggregate gross notional value of the listed derivatives) consist of futures, options and swaps for which an Exchange may obtain information via the ISG, its members or affiliates, or for which a principal market is a market with which the Exchange has a CSSA.
- The aggregate gross notional value of listed derivatives based on any five or fewer underlying reference assets may not exceed 65% of the weight of the portfolio (including gross notional exposures), and the aggregate gross notional value of listed derivatives based on any single underlying reference asset may not exceed 30% of the weight of the portfolio (including gross notional exposures).
With respect to over-the-counter (OTC) derivatives, such as forwards, options and swaps on commodities, currencies and other financial instruments, or a basket or index of any of these, the Listing Standards permit no more than 20% of the assets in the portfolio to be invested in OTC derivatives (calculated as the aggregate gross notional value of the OTC derivatives).
The Listing Standards provide an efficient framework for Active ETFs that are able to meet the above criteria at the time of listing and on a continuous basis. Many new Active ETFs may be able to come to market expeditiously in reliance on the Listing Standards. Active ETFs that are already listed may continue to rely upon their existing Rule 19b-4 orders, particularly to the extent such orders provide greater flexibility than the Listing Standards. For those Active ETFs that are unable to meet the limitations imposed by the Listing Standards, the Rule 19b-4 filing process remains available for the Exchanges and Active ETF sponsors that seek a path to list an Active ETF with more flexible portfolio standards.