Federal Register, Volume 79 Issue 207 (Monday, October 27, 2014)

[Federal Register Volume 79, Number 207 (Monday, October 27, 2014)]
[Notices]
[Pages 63964-63971]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-25438]

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SECURITIES AND EXCHANGE COMMISSION

[Investment Company Act Release No. 31301; 812-13953]

Spruce ETF Trust, et al.; Notice of Application

October 21, 2014.
AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Notice of an application for exemptive relief.

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SUMMARY OF APPLICATION: Applicants request an order under section 6(c)
of the Investment Company Act of 1940 (``Act'') for an exemption from
sections 2(a)(32), 5(a)(1), 22(d) and 22(e) of the Act and rule 22c-1
under the Act, under sections 6(c) and 17(b) of the Act for an
exemption from sections 17(a)(1) and 17(a)(2) of the Act, and under
section 12(d)(1)(J) of the Act for an exemption from sections
12(d)(1)(A) and (B) of the Act. If granted, the requested order would
permit several registered open-end investment companies that are
actively managed exchange traded funds (each, an ``ETF'') to list and
trade without being subject to the current daily portfolio transparency
condition in actively managed ETF orders.

APPLICANTS: Spruce ETF Trust (the ``Trust''), BlackRock Fund Advisors
(the ``Adviser'') and BlackRock Investments, LLC (the ``Distributor'')
(together, the ``Applicants'').

FILING DATE: The application was filed on September 1, 2011.

HEARING OR NOTIFICATION OF HEARING: Interested persons may request a
hearing by writing to the Commission's Secretary and serving applicants
with a copy of the request, personally or by mail. Hearing requests
should be received by the Commission by 5:30 p.m. on November 17, 2014,
and should be accompanied by proof of service on applicants, in the
form of an affidavit or, for lawyers, a certificate of service.
Pursuant to rule 0-5 under the Act, hearing requests should state the
nature of the writer's interest, any facts bearing upon the
desirability of a hearing on the matter, the reason for the request,
and the issues contested. Persons who wish to be notified of a hearing
may request notification by writing to the Commission's Secretary.
Absent a request for a hearing that is granted by the Commission, the
Commission intends to issue an order under the Act denying the
application.

ADDRESSES: Secretary, U.S. Securities and Exchange Commission, 100 F
Street NE., Washington, DC 20549-1090. Applicants: c/o BlackRock Fund
Advisors, 400 Howard Street, San Francisco, California 94105.

FOR FURTHER INFORMATION CONTACT: Deepak T. Pai, Senior Counsel; Kay-
Mario Vobis, Senior Counsel; or Dalia Osman Blass, Assistant Chief
Counsel, at (202) 551-6821 (Division of Investment Management, Chief
Counsel's Office).

SUPPLEMENTARY INFORMATION: The following is a summary of the
application. The complete application may be obtained via the
Commission's Web site by searching for the file number, or an applicant
using the Company name box, at http://www.sec.gov/search/search.htm or
by calling (202) 551-8090.

I. Introduction

1. Applicants seek to introduce a novel type of actively managed
exchange-traded fund (``ETF'') that would not be required to disclose
its portfolio holdings on a daily basis. Due to their characteristics,
ETFs (including those proposed by Applicants) are only permitted to
operate subject to Commission orders that provide exemptive relief from
certain provisions of the Act and rules thereunder.\1\ Accordingly,
Applicants seek an order under section 6(c) of the Act for an exemption
from sections 2(a)(32), 5(a)(1), 22(d) and 22(e) of the Act and rule
22c-1 thereunder; and under sections 6(c) and 17(b) of the Act granting
an exemption from sections 17(a)(1) and 17(a)(2) of the Act, and under
section 12(d)(1)(J) for an exemption from sections 12(d)(1)(A) and (B)
of the Act.
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\1\ The Commission first granted exemptive relief to operate
ETFs in the early 1990s when the first index-based ETFs were
developed. See SPDR Trust Series I, Investment Company Act Release
Nos. 18959 (Sept. 17, 1992) (notice) and 19055 (Oct. 26, 1992)
(order).
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2. As discussed below, the Commission preliminarily believes that
Applicants' proposed ETFs do not meet the standard for exemptive relief
under section 6(c) of the Act. Section 6(c) allows the Commission to
exempt any person, security, or transaction, or any class thereof, only
``if and to the extent that such exemption is necessary or appropriate
in the public interest and consistent with the protection of investors
and the purposes fairly intended by the policy and provisions of [the
Act].'' \2\ Accordingly, the Commission preliminarily intends to deny
the application.\3\
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\2\ 15 U.S.C. 80a-6(c).
\3\ For this reason, the Commission finds it unnecessary to
consider whether the application meets the section 17(b) and section
12(d)(1)(J) standards for exemptive relief.
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II. Background

A. Open-End Investment Companies and Net Asset Value

3. The Act defines an investment company as an ``issuer'' of ``any
security'' which ``is or holds itself out as being engaged primarily .
. . in the business of investing . . . in securities.'' \4\ Shares in
an investment company represent proportionate interests in its
investment portfolio, and their value fluctuates in relation to the
changes in the value of that portfolio.
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\4\ 15 U.S.C. 80a-3(a); 80a-3(a)(1).
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4. The most common form of investment company, the ``open-end''

[[Page 63965]]

investment company or mutual fund, is required by law to redeem its
securities on demand at a price approximating their proportionate share
of the fund's net asset value (``NAV'') at the time of redemption.\5\
These funds also continuously issue and sell new shares, thereby
replenishing their investment capital.
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\5\ Section 22(d) of the Act prohibits a dealer from selling a
redeemable security that is being offered to the public by or
through an 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 require that fund shareholders be treated equitably when buying
and selling their fund shares.
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5. Because open-end investment companies are required by law to
redeem their shares based on investors' demands, shares of the funds
have historically not traded on exchanges or in other secondary
markets.\6\
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\6\ This stems from section 22(d) of the Act, which in effect
fixes the prices at which redeemable securities, including open-end
shares, are sold. The result is a system that precludes dealers from
making a secondary market in open-end shares.
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B. Exemptions Under the Act for Actively Managed ETFs

6. ETFs, including those proposed by Applicants, are a type of
open-end fund. But unlike traditional open-end funds, ETFs are made
available to investors primarily through secondary market transactions
on exchanges.
7. In order for this to take place, ETFs require various exemptions
from the provisions of the Act and the rules thereunder. Critically, in
granting such exemptions to date, the Commission has required that a
mechanism exist to ensure that ETF shares would trade at a price that
is at or close to the NAV per share of the ETF.\7\
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\7\ This has been a required representation in all ETF orders
since the Commission issued the first order. See supra note 1.
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8. Such a mechanism is essential for ETFs to operate because ETFs
do not sell or redeem their individual shares at NAV per share as
required by the Act. Instead, large broker-dealers that have
contractual arrangements with an ETF (each, an ``Authorized
Participant'') purchase and redeem ETF shares directly from the ETF,
but only in large blocks called ``creation units.'' An Authorized
Participant that purchases a creation unit of ETF shares first deposits
with the ETF a ``basket'' of securities and other assets (e.g., cash)
identified by the ETF that day, and then receives the creation unit of
ETF shares in return for those assets. The basket is generally
representative of the ETF's portfolio and is equal in value to the
aggregate NAV of ETF shares in the creation unit. After purchasing a
creation unit, the Authorized Participant may sell the component ETF
shares in secondary market transactions. Investors then purchase
individual shares in the secondary market. The redemption process is
the reverse of the purchase process: the Authorized Participant
acquires a creation unit of ETF shares and redeems it for a basket of
securities and other assets.
9. The combination of the creation and redemption process with the
secondary market trading in ETF shares provides arbitrage opportunities
that, if effective, keep the market price of the ETF's shares at or
close to the NAV per share of the ETF.\8\ For example, if an ETF's
shares begin trading on national securities exchanges at a ``discount''
(a price below the NAV per share of the ETF), an Authorized Participant
can purchase ETF shares in secondary market transactions and, after
accumulating enough shares to comprise a creation unit, redeem them
from the ETF in exchange for the more valuable securities in the ETF's
redemption basket. In addition to purchasing ETF shares, Authorized
Participants also are likely to hedge their intraday risk. Thus, for
example, when ETF shares are trading at a discount to the NAV per share
of the ETF, an Authorized Participant may also simultaneously short the
securities in the redemption basket. At the end of the day, the
Authorized Participant will return the creation unit of ETF shares to
the ETF in exchange for the ETF's redemption basket of securities and
other assets, which it will then use to cover its short positions.
Those purchases reduce the supply of ETF shares in the market, and thus
tend to drive up the market price of the shares to a level closer to
the NAV per share of the ETF.\9\
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\8\ See Investment Company Institute, 2014 Investment Company
Fact Book (2014) (``ICI Fact Book''), at 60.
\9\ The Authorized Participant's purchase of the ETF shares in
the secondary market, combined with the sale of the redemption
basket securities, may also create upward pressure on the price of
ETF shares and/or downward pressure on the price of redemption
basket securities, driving the market price of ETF shares and the
value of the ETF's portfolio holdings closer together.
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10. Conversely, if the market price for ETF shares reflects a
``premium'' (a price above the NAV per share of the ETF), an Authorized
Participant can deposit a basket of securities in exchange for the more
valuable creation unit of ETF shares, and then sell the individual
shares in the market to realize its profit. An Authorized Participant
may also hedge its intraday risk when ETF shares are trading at a
premium. Thus, for example, when the shares of an ETF are trading at a
premium, an Authorized Participant may buy the securities in the
purchase basket in the secondary market and sell short the ETF shares.
At the end of the day, the Authorized Participant will deposit the
purchase basket of securities and other assets in exchange for a
creation unit of ETF shares, which it will then use to cover its short
positions. The Authorized Participant will receive a profit from having
paid less for the ETF shares than it received for the securities in the
purchase basket. These transactions would increase the supply of ETF
shares in the secondary market, and thus tend to drive down the price
of ETF shares to a level closer to the NAV per share of the ETF.\10\
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\10\ The Authorized Participant's purchase of the purchase
basket securities, combined with the sale of ETF shares, may also
create downward pressure on the price of ETF shares and/or upward
pressure on the price of purchase basket securities, bringing the
market price of ETF shares and the value of the ETF's portfolio
holdings closer together.
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11. Market participants can also engage in arbitrage activity
without using the creation or redemption processes described above. For
example, if a market participant believes that an ETF is overvalued
relative to its underlying or reference assets, the market participant
may sell short ETF shares and buy the underlying or reference assets,
wait for the trading prices to move toward parity, and then close out
the positions in both the ETF shares and the underlying or reference
assets to realize a profit from the relative movement of their trading
prices. Similarly, a market participant could buy ETF shares and sell
the underlying or reference assets in an attempt to profit when an
ETF's shares are trading at a discount to the ETF's underlying or
reference assets. As discussed above, the trading of an ETF's shares
and the ETF's underlying or reference assets may bring the prices of
the ETF's shares and its portfolio assets closer together through
market pressure.
12. In assessing whether to grant exemptive relief to actively
managed ETFs in the past, the Commission has required a mechanism that
would keep the market prices of ETF shares at or close to the NAV per
share of the ETF. To date, this mechanism has been dependent on daily
portfolio transparency.\11\ This transparency

[[Page 63966]]

provides market makers and other market participants with an important
tool to value the ETF portfolio on an intraday basis, which, in turn,
enables them to assess whether an arbitrage opportunity exists. It is
the exercise of such arbitrage opportunities that keeps the market
price of ETF shares at or close to the NAV per share of the ETF. This
close tie between market price and NAV per share of the ETF is the
foundation for why the prices at which retail investors buy and sell
ETF shares are similar to the prices at which Authorized Participants
are able to buy and redeem shares directly from the ETF at NAV. In
granting relief from section 22(d) of the Act and rule 22c-1 under the
Act, the Commission relies on this close tie between what retail
investors pay and what Authorized Participants pay to make the finding
that the ETF's shareholders are being treated equitably when buying and
selling shares.\12\ The Commission therefore has granted such exemptive
relief to date only to those actively managed ETFs that have provided
daily transparency of their portfolio holdings.
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\11\ The condition for daily portfolio transparency has
consistently been one of the conditions to the exemptive relief
issued to actively managed ETFs by the Commission. See PowerShares
Capital Management LLC, et al., Investment Company Act Release Nos.
28140 (Feb. 1, 2008) (notice) and 28171 (Feb. 27, 2008) (order).
\12\ See supra note 5 and accompanying text.
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III. The Application

A. The Applicants

13. The Trust is a business trust organized under the laws of
Delaware and will be registered under the Act as an open-end management
investment company with multiple series (each, a ``proposed ETF'').
Applicants propose to offer 13 initial proposed ETFs, each of which
will use a variety of active management strategies to meet its
investment objectives. The proposed ETFs include long/short funds, and
may invest a portion of their assets (up to a third of the total
assets) in derivatives and foreign securities.\13\
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\13\ See Securities Exchange Act Release No. 34-72787 (Aug. 7,
2014), File No. SR-BATS-2014-018 (``19b-4 Notice''), at 14-15.
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14. The Adviser, a corporation organized under the laws of
California, is registered as an investment adviser under the Investment
Advisers Act of 1940 (``Advisers Act'') and would serve as the
investment adviser to the initial proposed ETFs. The Distributor, a
Delaware limited liability company, is a registered broker-dealer under
the Securities Exchange Act of 1934, as amended.

B. Applicants' Proposal

15. Applicants seek exemptive relief under section 6(c) of the Act
to allow them to introduce several actively managed ETFs that would not
disclose their portfolio holdings on a daily basis. Applicants note
that actively managed ETFs with transparent portfolios are susceptible
to ``front running'' and ``free riding'' by other investors and/or
managers which can harm, and result in substantial costs to, the
actively managed ETFs.\14\
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\14\ Application at 40. See also Murray Coleman, Could a Stock
ETF Cloak its Portfolio (May 7, 2012), available at http://online.wsj.com/news/articles/SB10001424052702304432704577348261039833588 (noting that if traders
can identify the shares in which a fund manager is building a
position, they can start buying the shares ahead of the manager and
drive up the price while the manager is still buying the stock).
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16. As explained below, the Applicants propose to operate actively
managed ETFs that would not disclose their portfolio holdings on a
daily basis. Applicants state that the relief requested in their
application is similar to the relief granted in exemptive orders issued
to existing actively managed ETFs, except for certain differences
permitting the proposed ETFs to operate on a non-transparent basis.
These material differences are highlighted below:
a. Prospectus and Portfolio Disclosures: Applicants would not
provide the daily disclosure of a proposed ETF's portfolio holdings
that is a condition in all exemptive orders issued to existing actively
managed ETFs. Applicants would instead only provide the standard
portfolio and other disclosures required for traditional mutual funds.
Traditional mutual funds are required to disclose their portfolio
holdings only on a quarterly basis, with a lag of not more than 60
days.\15\
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\15\ Shareholder reports, including a schedule of portfolio
holdings, must be transmitted to shareholders semi-annually, within
60 days of the end of the second and fourth fiscal quarters. See
Rule 30e-1. A complete schedule of portfolio holdings must be filed
with the Commission on Form N-CSR within 10 days of the transmission
of the shareholder report. See Rule 30d-1. Complete portfolio
holdings also must be filed on Form N-Q within 60 days of the end of
the first and third fiscal quarters. See Rule 30b1-5.
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b. Indicative Intraday Value: Investors and others acquiring the
proposed ETFs' shares would primarily have to rely on the intraday
indicative value (the ``IIV''), which would be disseminated by an
exchange every 15 seconds during the trading day,\16\ to assess the
value of a proposed ETF due to the lack of portfolio transparency. The
IIV would be calculated by a calculation agent who would receive the
daily list of securities constituting the proposed ETF's portfolio from
the ETF sponsor.\17\ As acknowledged by the Applicants, the IIV is
based on the value of the proposed ETF's portfolio and is calculated by
the calculation agent using the last available market quotation or sale
price of the proposed ETF's portfolio holdings.\18\ As further
acknowledged by the Applicants, the IIV is not the NAV; rather, it is a
reference produced by a third party seeking to approximate the proposed
ETF's underlying per share net asset value.\19\ Applicants also concede
that the IIV is not intended as a ``real-time NAV'' and (unlike the
NAV) would not include extraordinary expenses or liabilities booked
during the day.\20\ As discussed below, an ETF's portfolio could
contain securities and other assets all (or most) of which need to be
fair valued in order for the IIV to be accurate.\21\
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\16\ We note that the IIV is not disseminated during early and
late trading sessions when market participants would still be
trading the proposed ETFs' shares. Therefore, there would be no
pricing signal at all for these trades.
\17\ See infra note 35.
\18\ Application at 32. See also Matt Hougan, The Flaws in iNAV,
104 Exchange-Traded Funds Report (``Hougan ETF Report''), 5, 10
(2009).
\19\ Application at 31.
\20\ Id.
\21\ See infra notes 38-45 and accompanying text.
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c. Blind Trust Mechanism: Applicants propose for creation unit
purchases to be made in cash and for redemptions to be effected in-kind
through a ``blind trust'' established for each Authorized Participant.
Applicants assert that the delivery of redemption securities into the
blind trust would allow the ETF to retain the benefits associated with
in-kind redemptions,\22\ while shielding the identity of the ETF's
portfolio securities. Based on the standing instructions of the
Authorized Participant, the blind trust would sell or otherwise manage
the securities on behalf of the Authorized Participant without
disclosing the contents of the underlying portfolio.
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\22\ Because redemptions from ETFs are often made in-kind, ETFs
may offer certain tax efficiencies compared to traditional mutual
funds by avoiding the need to sell assets and potentially experience
a taxable event. In addition, ETFs do not bear the brokerage costs
associated with liquidating portfolio instruments to meet redemption
requests. We note that it is unclear whether Applicants' proposed
ETFs would experience the same in-kind benefits experienced by
existing ETFs. The blind trust structure is likely to introduce
additional costs because, among other things, the Authorized
Participants would not be able to manage the sale of the securities
to enhance arbitrage profits. See Comment Letter of Gary Gastineau,
File No. SR-NYSEArca-2014-10 (Mar. 18, 2014) (``Gastineau March 2014
Letter''), at 3-5 for a discussion of the potential issues presented
by this structure.
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d. Back-up Redemption Option: Applicants have proposed a back-up
mechanism that would allow retail investors to redeem individual shares
directly from the proposed ETFs in the event of a persistent and
significant

[[Page 63967]]

deviation of closing market price from NAV. Under the proposal, retail
investors exercising the option would be subject to a redemption fee of
up to 2% of the value of shares redeemed and would likely be charged
additional brokerage commissions. Further, the redemption option would
become available to retail investors only after the proposed ETF's
shares have persistently been trading at a discount of at least 5% from
NAV for 10 consecutive business days. The option would remain open for
15 days; if a discount persists, a new option would commence on the
next business day.

IV. Analysis of the Application

17. As noted above, the Applicants have sought exemptive relief
under several provisions of the Act--each of which the Applicants would
need to obtain in order to operate their proposed ETFs.
18. Applicants state that the relief requested in their application
is similar to the relief granted in exemptive orders issued to existing
actively managed ETFs, except for certain differences permitting the
proposed ETFs to operate on a non-transparent basis.
19. As discussed below, however, the Commission preliminarily
believes that the specific features proposed by the Applicants that
would cause the proposed ETFs to operate without transparency fall far
short of providing a suitable alternative to the arbitrage activity in
ETF shares that is crucial to helping keep the market price of current
ETF shares at or close to the NAV per share of the ETF.\23\
Accordingly, the Commission preliminarily believes that it is not in
the public interest or consistent with the protection of investors or
the purposes fairly intended by the policy and provisions of the Act to
grant the exemptive relief under section 6(c) that the Applicants seek.
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\23\ Staff in the Division of Economic and Risk Analysis
provided advice and analyses relevant to the Commission's
conclusions, discussed in more detail below.
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A. ETF Prospectus Disclosure and IIV Dissemination

20. Applicants assert that ETF prospectus disclosure and the
dissemination of the IIV every 15 seconds during the trading day would
be sufficient to allow the arbitrage mechanism to function effectively
after a few days of trading.\24\ Applicants further assert that market
participants do not need any additional information about the proposed
ETF's portfolio so long as they are able to create correlations against
and, over time, evaluate how various market factors affect the
disseminated IIV. According to Applicants, this process is referred to
as ``reinforcement learning.''\25\
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\24\ Application at 37-43.
\25\ According to Applicants, reinforcement learning is
dependent on statistical arbitrage. See text following supra note
10. Applicants assert that market makers would use the proposed
ETF's market price, IIV and daily NAV to construct a hedging
portfolio for the proposed ETF. The market makers would then engage
in statistical arbitrage between their hedging portfolio and the
shares of the proposed ETF--i.e., buying and selling one against the
other during the trading day and evaluating the effectiveness of
their hedging portfolio at the day's end. Applicants further assert
that after a few days of trading, there would be sufficient data for
a market maker to run a statistical analysis that would result in
the market maker's spreads being tightened substantially around the
IIV. Application at 37-43.
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21. ETF prospectus disclosure will not assist the arbitrage
mechanism because such disclosure does not contain any material real-
time information necessary to creating or facilitating effective
arbitrage. Actively managed funds generally include very broad
investment objectives and strategies in order to provide investment
advisers with the maximum flexibility possible in managing the
portfolio, and do not include more specific, current information about
a fund's portfolio holdings.\26\ The Commission preliminarily believes
that it would be difficult, if not impossible, for market participants
to discern sufficient useful information from such broad disclosures.
Therefore, the lack of more specific information with respect to the
proposed ETF's investment objectives or principal investment strategies
may not enable market makers to effectively assess whether real-time
arbitrage opportunities in ETF shares exist and may discourage them
from making markets in ETF shares that would keep the share prices at
or close to the NAV per share of the ETF--a condition that may be
exacerbated during times of market stress.
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\26\ For example, Form N-1A requires mutual funds to disclose in
the prospectus and statement of additional information their
investment objectives or goals, principal investment strategies, and
the portfolio turnover rate during the most recent fiscal year. See,
e.g., Form N-1A, Items 2 to 4, and 9. As discussed above, mutual
funds are required to disclose their portfolio holdings quarterly.
See supra note 15 and accompanying text.
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22. Dissemination of the IIV at 15 second intervals throughout the
trading day does not fill this information void. Today, market makers
calculate their own NAV per share of the ETF with proprietary
algorithms that use an ETF's daily portfolio disclosure and available
pricing information about the assets held in the ETF's portfolio.\27\
They generally use the IIV, if at all, as a secondary or tertiary check
on the values that their proprietary algorithms generate. If the daily
portfolio holdings for the proposed ETFs are not available for market
makers to calculate current values of a proposed ETF, they will be
reliant principally on the IIV given the limitations of the prospectus
and quarterly portfolio disclosures. Even though the IIV continues to
be disseminated in conjunction with the full portfolio holdings and
basket of existing ETFs, its reliability as a primary pricing signal
for the proposed ETFs is questionable for the reasons discussed below.
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\27\ See David J. Abner, The ETF Handbook: How to Value and
Trade Exchange Traded Funds (2010), at 90 (``[s]ince stock trading
now takes place in microseconds, a lot can happen between two
separate 15-second quotes. Professional traders are not using
published IIVs as a basis for trading. Most, if not all, desks that
are trading ETFs are calculating their own [NAV of the ETF] based on
real time quotes . . . that they are generating within their own
systems.''). See also Comment Letter of BGFA, File No. S7-07-08 (May
16, 2008) (``BGFA 2008 Letter''), at n.43; and ICI Fact Book, supra
note 8, at 59.
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23. The IIV is stale data. Unlike market maker proprietary
algorithms, which rely on portfolio transparency and provide market
makers with real-time data to effectively trade in today's fast moving
markets, IIV dissemination frequency is inadequate for purposes of
making efficient markets in ETFs.\28\ Market makers operate at speeds
calculated in fractions of a second.\29\ In today's markets, 15 seconds
is too long for purposes of efficient market making and could result in
poor execution.\30\

[[Page 63968]]

Because an ETF is a derivative security, its current value changes
every time the value of any underlying component of the ETF portfolio
changes.\31\ Therefore, the IIV for a more frequently traded component
security might not effectively take into account the full trading
activity for that security, despite being available every 15 seconds.
For example, a large buy order for a component security held by the
proposed ETF could temporarily spike the price of that security and,
therefore, inflate the proposed ETF's contemporaneous IIV
calculation.\32\ The IIV for the proposed ETF cannot adjust for such
variations, whereas the NAV would.\33\ Therefore, relying on a stale
IIV as a primary pricing signal for market making in Applicants'
proposed ETFs would not result in an effective arbitrage mechanism.\34\
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\28\ The Commission previously issued a proposing release on a
proposed rule for certain ETFs. See Exchange-Traded Funds,
Investment Company Act Release No. 28193 (Mar. 11, 2008) (``2008 ETF
Rule Proposal''). Various industry members commenting on the 2008
ETF Rule Proposal noted that market makers did not rely on the IIV
because of either its staleness or unreliability. See, e.g., Comment
Letter of NYSE Arca, Inc., File No. S7-07-08 (May 29, 2008) (the
exchange noted that it ``is not convinced that the [IIV] is a
meaningful pricing tool for investors in light of the availability
of other pricing information. In fact, we believe that it is the
transparency of the portfolios [sic] holdings which permit [sic]
market makers and other professionals to arbitrage efficiently and
not the regular dissemination of an [IIV]. Some market participants
may choose to generate an [IIV] for their own use, using their own
calculation methodology to include financing costs, capital costs,
etc., in kind trading or arbitrage. Importantly, the [IIV] generated
by professionals is in real-time and not delayed by 15 or 60
seconds.''); and BGFA 2008 Letter, supra note 27, at n. 43 and n.
92. See also Matt Hougan, Ban iNAVs For ETFs (June 24, 2013),
available at http://www.indexuniverse.com/sections/blog/19037-hougan-ban-inavs-for-etfs.html.
\29\ See Comment Letter of ICI, File No. SR-NASDAQ-2012-117
(Nov. 8, 2012), (``ICI 2012 Letter''), at 4. See also ICI Fact Book,
supra note 8.
\30\ See, e.g., How To Minimize Your Cost Of Trading ETFs (June
22, 2009), ETF.com, available at http://www.etf.com/publications/journalofindexes/joi-articles/6042-how-to-minimize-your-cost-of-trading-etfs.html, at Figure 2 and related discussion. See also ICI
2012 Letter, supra note 29 (``Professional equity traders operate at
speeds calculated in fractions of a second. In such markets, 15
seconds can be an eternity, and establishing an order price based on
data that is nearly 15 seconds old could result in poor
execution.'').
\31\ In particularly volatile markets, the dissemination lag of
IIV values (i.e., every 15 seconds) may misrepresent the actual
value of the ETF. See Understanding iNAV, ETF.com, available at
http://www.etf.com/etf-education-center/21028-understanding-inav.html; Gary L. Gastineau, Exchange-Traded Funds Manual, Second
Edition (2010), at 200-202.
\32\ See, e.g., ICI 2012 Letter, supra note 29.
\33\ See, e.g., ICI 2012 Letter, supra note 29. See also
Gastineau March 2014 Letter, supra note 22, at 10, for a more
detailed discussion of why the IIV would at best be a ``lagging
indicator of actual portfolio values'' during times of rapid market
movement.
\34\ An IIV that is disseminated at more frequent intervals
could present a different set of problems, as it may enable third
parties to reverse engineer the underlying portfolio using data
analysis. Therefore, changing the frequency of dissemination would
not appear to be a viable option to the extent Applicants' objective
is to prevent disclosure of the proposed ETF's portfolio. See also
infra note 37 and accompanying text.
---------------------------------------------------------------------------

24. The IIV is not subject to meaningful standards. Because there
are no uniform methodology requirements, the IIV can be calculated in
different ways rendering it potentially arbitrary and inconsistent.\35\
Also, Applicants acknowledge that no party has agreed to take
responsibility for the accuracy of IIV calculation.\36\ Therefore, the
Commission's preliminary conclusion is that the IIV calculation
methodology is not appropriate for the IIV to be used as a primary
pricing signal because it is potentially unreliable and susceptible to
errors.\37\
---------------------------------------------------------------------------

\35\ See, e.g., ICI 2012 Letter, supra note 29 (``[M]any parties
participate in the calculation, publication, and dissemination of
[IIV]. The ETF sponsor provides an independent calculation agent
with the daily list of securities constituting an ETF's creation
basket (which for U.S. equity ETFs is typically, but not always, a
pro rata slice of the ETF's portfolio). The calculation agent
separately obtains market pricing information for each of the
component securities from a third party source, such as the exchange
or a pricing vendor, and calculates the estimated per-share value of
an ETF share. This process creates several opportunities for errors:
for example, an ETF may report a basket inaccurately; a calculation
agent may receive faulty data from a pricing vendor; or an error may
be made in the calculation process. We understand that such errors
are not infrequent.'' [emphasis added]).
\36\ Applicants explicitly disclaim making any warranty by the
ETFs as to the accuracy of the IIV. The Adviser would merely use
``commercially reasonable efforts to assure that the calculation
agent has an accurate listing of all securities in each [f]und's
portfolio as of the beginning of trading on each day the [f]und is
traded.'' Similarly, ``[a]lthough the calculation agent will not
guarantee the accuracy of the IIV, the contract with the calculation
agent will require that it use commercially reasonable efforts to
calculate the IIV correctly. . . .'' Application at 31.
\37\ As is the case with more frequent dissemination, an IIV
that is sufficiently accurate and precise may also enable third
parties to reverse engineer the underlying portfolio using data
analysis. Such an ETF would thus once again become vulnerable to
front running if its portfolio can be reverse engineered by others.
See Gastineau March 2014 Letter, supra note 22, at 15.
---------------------------------------------------------------------------

25. The IIV would be inaccurate for certain securities and asset
classes. Because the IIV is constructed using last available market
quotations or sale prices and not fair value prices for the underlying
assets, it can be inaccurate.\38\ For example, as some securities do
not trade frequently, the IIV would reflect the last quoted or sale
price which could be stale and no longer reflect their current
value.\39\ Other securities may not have yet opened for trading on a
particular trading day or may be subject to an intraday interruption in
trading.\40\
---------------------------------------------------------------------------

\38\ See Hougan ETF Report, supra note 18. NAV includes fair
value pricing, and with daily portfolio disclosure, market makers
can estimate fair value on their own for the holdings of current
ETFs.
\39\ See, e.g., ICI 2012 Letter, supra note 29.
\40\ See Gastineau March 2014 Letter, supra note 22 (noting that
an exchange may institute a trading halt in a stock to address a
significant order imbalance or in connection with release of
important company news).
---------------------------------------------------------------------------

26. Applicants note that up to 15% of the proposed ETFs' total
assets could be in illiquid securities.\41\ Illiquid securities often
fall within the category of securities for which there is no readily
available market quotation and their fair value must be determined in
good faith by the fund's directors.\42\ Therefore, a significant amount
of illiquid securities in a proposed ETF's portfolio could exacerbate
the deviation between the IIV and the NAV per share of the ETF because
the accurate value of illiquid securities is determined by current fair
valuation (reflected in the NAV) rather than use of stale pricing data
(reflected in the IIV).\43\
---------------------------------------------------------------------------

\41\ See 19b-4 Notice, supra note 13.
\42\ 15 U.S.C. 80a-2(a)(41)(B). See also Independent Directors
Council, Fundamentals for Newer Directors (Feb. 2014), available at
http://fundamentals.idc.org/specific/specific_pricing, at 27.
\43\ ETF sponsors seek to minimize exposure to assets that could
impact this deviation because they can make arbitrage opportunities
more difficult to evaluate. See Comment Letter of ICI, File No. S7-
07-08 (May 19, 2008). See also Comment Letter of The American Stock
Exchange LLC, File No. S7-20-01 (Mar. 5, 2002) (``Ultimately it is
in the interest of the sponsor and investment adviser to provide for
effective arbitrage opportunities. It is unlikely that an . . . ETF
sponsor would be able to convince the critical market participants
such as specialists, market makers, arbitragers and other Authorized
Participants to support a product that contained illiquid securities
to a degree that would affect the liquidity of the ETF, making it
difficult to price, trade and hedge, ultimately leading to its
failure in the marketplace.'').
---------------------------------------------------------------------------

27. Additionally, the proposed ETFs may invest a portion of their
assets (up to a third of the total assets) in derivatives and foreign
securities.\44\ Thinly traded derivatives contracts may lack readily
observable market prices that could be used to update the IIV in real
time. Similarly, because international securities are often traded
outside the ETF's regular trading hours, their last available market
prices could be up to a day old and no longer reflect their current
value.\45\ Therefore, to the extent pricing inputs are unavailable or
become stale for these alternative asset classes, the IIV would no
longer be an accurate reflection of the NAV per share of the ETF.
---------------------------------------------------------------------------

\44\ See 19b-4 Notice, supra note 13.
\45\ See, e.g., ICI 2012 Letter, supra note 29; Ari I. Weinberg,
An Extra Data Point on ETFs* (Aug. 4, 2013), available at http://online.wsj.com/news/articles/SB10001424127887323993804578611773169627276 (further noting that
``[i]nternational markets also observe different holidays, meaning
that a stock might not trade for several days even while an ETF that
holds it is trading in the U.S.--leaving even more time for events
that could result in a significantly different price when the stock
starts trading again.'').
---------------------------------------------------------------------------

28. IIV inaccuracies can increase ETF tracking errors. Errors in
the IIV will likely lead to errors in estimating the factors that a
market maker must consider when valuing a proposed ETF and constructing
a hedging portfolio.\46\ Therefore, market makers may not be able to
construct accurate hedging portfolios for the ETF shares.\47\ This
would increase the tracking error associated with the hedging
portfolios described above. As a result, tracking

[[Page 63969]]

errors between intraday ETF prices and NAV per share of the proposed
ETF would also likely increase because greater tracking errors in
hedging portfolios would expose the market maker's position to greater
risk.\48\
---------------------------------------------------------------------------

\46\ Such factors would include the market, asset class, sector
and other risk factors. Market makers would need to estimate these
exposures for a proposed ETF in order to construct hedging
portfolios.
\47\ This calls into question the reinforcement learning process
which may not perform adequately during periods of heightened market
volatility. See Sanmay Das, Intelligent Market-Making in Artificial
Financial Markets, Massachusetts Institute of Technology--Artificial
Intelligence Laboratory, AI Technical Report 2003-005, at 37.
\48\ A commonly accepted assumption in economic models of market
making is that market makers' bid-ask spreads compensate them for a
number of costs including the risk they bear in their positions. See
Maureen O'Hara, Market Microstructure Theory, First Edition (1998),
at 35. Therefore, greater tracking errors in hedging portfolios for
the proposed ETFs will likely result in higher bid-ask spreads and
greater tracking errors between intraday ETF prices and the NAV of
the ETF.
---------------------------------------------------------------------------

29. In addition, it may be more difficult for market makers to
construct appropriate hedging portfolios from the IIV for proposed ETFs
with higher portfolio turnover. In particular, changing portfolio
allocations can cause the factors that a market maker must consider
when valuing a proposed ETF and constructing a hedging portfolio to
fluctuate more rapidly. This would in turn increase uncertainty around
the market maker's estimates of these factors.\49\ Therefore, proposed
ETFs with more complex investment strategies involving dynamic factors
will likely have higher tracking errors and bid-ask spreads if there is
lack of sufficient information for market participants to construct
tight hedges.\50\
---------------------------------------------------------------------------

\49\ In contrast, turnover would introduce no such uncertainty
in ETFs with daily portfolio disclosure as the end-of-day NAV would
be marked to the previously disclosed portfolio, which is known by
market makers.
\50\ Applicants are seeking relief to launch, among others,
long/short equity proposed ETFs. These types of funds have a higher
portfolio turnover on average than that of actively managed equity
funds. See Jing-Zhi Huang and Ying Wang, Should Investors Invest in
Hedge Fund-Like Mutual Funds? Evidence from the 2007 Financial
Crisis, 22 J. of Financial Intermediation 482 (2013), available at
http://dx.doi.org/10.1016/j.jfi.2012.11.004, at 486-487 (finding
that average turnover across 130/30 equity mutual funds was 196%
from June 2003 until December 2009 versus less than 70% across all
actively managed mutual funds in a comparable time period). These
proposed ETFs also could have more thinly traded securities that
could be more susceptible to price volatility during stressed market
conditions. Therefore, it may be difficult for market makers to
construct appropriate hedging portfolios from the IIV, making the
proposed ETFs also likely to have higher tracking errors and bid-ask
spreads.
---------------------------------------------------------------------------

30. IIV inaccuracies can increase during periods of market stress
or volatility. Market stress can reduce liquidity in certain assets and
consequently increase errors in IIV as the portfolio becomes
increasingly illiquid and current market prices become more difficult
to determine. In addition, volatility can increase errors around prices
used in IIV calculations as volatility can increase the movement of
prices.
31. In stressed markets, confidence in the pricing of (and in turn,
the knowledge of) the ETF portfolio becomes increasingly important for
market makers to continue to quote prices in ETF shares.\51\ By itself,
the IIV of a proposed ETF likely will not instill such confidence in a
proposed ETF's pricing because, as discussed above, the IIV is
potentially unreliable and susceptible to errors.\52\ Nevertheless, a
market maker that questions the current market price or IIV for an ETF
can check those numbers against the NAV per share of the ETF output
from its proprietary algorithm if the ETF has a fully transparent
portfolio. That same market maker, however, would not be able to run a
similar cross-check on those figures against a non-transparent ETF like
the ones proposed by Applicants. Due to the inherent weaknesses of the
IIV as a stand-alone metric, Applicants' proposal (which relies heavily
upon the IIV as a substitute for full portfolio transparency) likely
will not offer enough information about the underlying portfolio. As
discussed below, this, in turn, likely would discourage market makers
from making markets that would keep the market price for the proposed
ETF's shares at or close to the NAV per share of the ETF, particularly
under stressed market conditions when the need for real-time and
verifiable pricing information becomes more acute.\53\
---------------------------------------------------------------------------

\51\ See, e.g., Report to the Joint Advisory Committee on
Emerging Regulatory Issues, Staffs of the CFTC and SEC (Sept. 20,
2010) (``Flash Crash Report''), at 4-6 (noting that buy-side and
sell-side interest returned only after market makers were able to
verify the integrity of their data and systems and that they had to
assess the risks of continuing to trade during the events of May 6,
2010).
\52\ See supra notes 28-37 and accompanying text.
\53\ See infra Section V.
---------------------------------------------------------------------------

32. Accordingly, the Commission's preliminary conclusion is that
use of the IIV as a primary pricing signal for market making in
Applicants' proposed ETFs would not result in an effective arbitrage
mechanism.

B. Quarterly Release of Portfolio Holdings

33. Applicants also propose providing their portfolio holdings
disclosures on a quarterly basis, with a lag of not more than 60 days.
But such disclosures would quickly lose their relevance for purposes of
valuing or hedging the proposed ETFs because the content of their
portfolios can change on a daily basis. This problem is heightened for
ETFs with active management strategies that involve high portfolio
turnover and alternative asset classes.\54\ Again, this may discourage
market makers from making markets that would keep the market price for
the proposed ETF's shares at or close to the NAV per share of the ETF,
particularly during times of market stress when the need for real-time
pricing information becomes more acute.
---------------------------------------------------------------------------

\54\ Antti Petajisto, Active Share and Mutual Fund Performance,
69 Financial Analysts Journal 73 (2013), available at http://www.cfapubs.org/doi/pdf/10.2469/faj.v69.n4.7, at 83. The study found
that annual turnover across U.S. all-equity mutual funds is 87%. As
a result, approximately 14% of the portfolio changes over the 60
days following the portfolio disclosure (prorating annual turnover
of 87% for 60 days) and an additional 22% of the portfolio changes
over the course of the following quarter (prorating annual turnover
of 87% for three months). Therefore, there may be significant
tracking errors between an ETF's current portfolio holdings and its
prior quarterly portfolio disclosure.
---------------------------------------------------------------------------

C. Back-Up Redemption Option

34. In light of concerns about the effect on retail investors if
the arbitrage mechanism failed to keep market prices at or close to the
NAV of the proposed ETFs, Applicants proposed a redemption option that,
in their view, would act as a ``fail-safe'' mechanism in the event of a
persistent and significant deviation of closing market price from NAV.
For the reasons discussed below, the Commission preliminarily believes
that this redemption option does not remedy the defects with
Applicants' proposal outlined above such that exemptive relief would be
appropriate.
35. Under the proposal, retail investors exercising the redemption
option would be subject to redemption and brokerage fees, which would
likely discourage use of the option. Specifically, retail investors
exercising the redemption option would be subject to a redemption fee
of up to 2% of the value of shares redeemed. In addition, retail
investors would likely be charged additional brokerage commissions to
exercise the option. These fees and costs may dissuade retail investors
from exercising a redemption option meant to provide retail investors
with the ability to transact with the ETF on an equal footing with the
Authorized Participants.\55\
---------------------------------------------------------------------------

\55\ An economically rational investor who seeks to exercise the
option is likely not to redeem until a trading discount to IIV in
the secondary market exceeds the costs to redeem (i.e., the
redemption fee plus the brokerage charges). Given that typical bid/
ask spreads for ETFs with underlying diversified domestic equity
holdings average 4 basis points, a redemption fee set at 2% will
cost the investor 200 basis points (not including brokerage charges)
to exit the proposed ETFs. See Antti Petajisto, Inefficiencies in
the Pricing of Exchange-Traded Funds (Sept. 20, 2013), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000336
(``Petajisto ETF Study''), at Table III. This assumes that the
investor has the information necessary (IIV, bid price for the
shares, redemption fee, brokerage charges) to make the determination
of whether to redeem directly from the proposed ETFs or sell on the
market. See generally, Matt Hougan, The Flaws in the iNAV, Exchange-
Traded Funds Report (July 2009), at 5 (noting that investors would
have to have deep quantitative experience to create models to see if
they were getting fair prices on ETF trades today); and John
Beshears, James Choi, David Laibson, and Brigitte C. Madrian, How
Does Simplified Disclosure Affect Individuals' Mutual Fund Choices?,
in Explorations in the Economics of Aging, edited by David A. Wise
(2011) (noting that many retail investors lack the ability to
perform even elementary calculations to compare investment options
with differing sales fees).

---------------------------------------------------------------------------

[[Page 63970]]

36. Moreover, the proposed redemption option is also problematic
because it would become available to investors only after ETF shares
have persistently been trading at a discount of at least 5% from NAV
for 10 consecutive business days. This would result in disparate
treatment of investors compared to Authorized Participants and would
further restrict investors' ability to transact at prices at or near
NAV. The Commission is concerned that forcing investors to remain
invested in a product that is trading at a significant discount to NAV
per share for two weeks before the redemption option is available may
lead to significant investor harm in the interim.\56\ Investors would
not be able to exit or would have to exit at a price substantially
below the NAV per share of the ETF, which would be contrary to the
foundational principle underlying section 22(d) and rule 22c-1 under
the Act that all shareholders be treated equitably when buying and
selling their fund shares.\57\ In the meantime, Authorized Participants
would have the advantage of transacting directly with the ETF on a
daily basis at NAV.
---------------------------------------------------------------------------

\56\ See, e.g., Petajisto ETF Study, supra note 55, at 18
(generally discussing economic magnitude of mispricings).
\57\ See supra note 5 and accompanying text.
---------------------------------------------------------------------------

37. But even if Applicants were able to address the Commission's
concerns about the retail redemption option, this would not address the
Commission's more fundamental concerns about Applicants' proposal. As
discussed above, Applicants are proposing an ETF model that the
Commission preliminarily believes would not have a sufficiently
effective arbitrage mechanism to consistently produce a secondary
market price for investors that would approximate NAV per share of the
ETF. The presence of a back-up retail redemption option does not cure
the inherently flawed structure of the proposed ETFs here.\58\
---------------------------------------------------------------------------

\58\ Applicants proposed the redemption option described above
in response to the staff's suggestion. The Commission preliminarily
believes that the inherent structural flaw of the proposed ETFs--
i.e., the potential lack of an effective arbitrage mechanism--cannot
be solved by the proposed fail-safe mechanism.
---------------------------------------------------------------------------

V. The Commission's Preliminary View

38. As discussed above, the Commission preliminarily believes that
Applicants have not provided an adequate substitute for portfolio
transparency such that the proposed ETFs would consistently trade at or
close to NAV. A close tie between market price and NAV per share of the
ETF is the foundation for why the prices at which retail investors buy
and sell ETF shares are similar to the prices at which Authorized
Participants are able to buy and redeem shares directly from the ETF at
NAV. This close tie between the prices paid by retail investors and
Authorized Participants is important because section 22(d) and rule
22c-1 under the Act are designed to require that all fund shareholders
be treated equitably when buying and selling their fund shares.\59\ In
fact, in granting relief from section 22(d) and rule 22c-1 under the
Act, the Commission has relied on this close tie between what retail
investors pay and what Authorized Participants pay to make the finding
that the ETF's shareholders are being treated equitably when buying and
selling shares.
---------------------------------------------------------------------------

\59\ See supra note 5.
---------------------------------------------------------------------------

39. The lack of portfolio transparency or an adequate substitute
for portfolio transparency coupled with a potentially deficient back-up
mechanism presents a significant risk that the market prices of ETF
shares may materially deviate from the NAV per share of the ETF--
particularly in times of market stress when the need for verifiable
pricing information becomes more acute. This would be contrary to the
foundational principle underlying section 22(d) and rule 22c-1 under
the Act--that shareholders be treated equitably--and may, in turn,
inflict substantial costs on investors, disrupt orderly trading and
damage market confidence in secondary trading of ETFs.

A. Substantial Costs to Investors

40. One of the primary benefits of current ETFs is that investors
are generally able to obtain a similar economic experience to investors
in traditional open-end funds (i.e., price at or close to NAV), but
without certain of the costs associated with such funds (e.g., transfer
agency fees). The Commission preliminarily believes the proposed ETFs
would not provide either element of this benefit if, as the Commission
anticipates, the arbitrage mechanism does not function properly. A
breakdown in the arbitrage mechanism could result in material
deviations between market price and NAV per share of the ETF. Such
deviations can hurt an investor. For example, if an investor places a
buy order and the ETF is trading at a premium, this would result in a
lower return for the investor as opposed to if the investor had bought
the ETF when its prices were at or close to the NAV per share of the
ETF or at a discount. As discussed above, the arbitrage mechanism
inherent in the ETF structure keeps these differences small.
41. In this regard, the Commission finds it significant that market
makers for Applicants expressed some skepticism during meetings with
Commission staff that the IIV could be used as the primary pricing
signal for ETFs with active management strategies that might involve
high portfolio turnover or alternative asset classes.\60\ They
indicated that they would likely use the pieces of information provided
by the Applicants (IIV, quarterly portfolio holdings disclosure and
prospectus disclosure) to construct hedge portfolios using
sophisticated algorithms.\61\ Their ability to construct hedge
portfolios that are generally predictive of the portfolio holdings of
the ETF is critical to their management of their exposure to the ETF.
If there is a break in the alignment between the market makers' hedge
portfolios and the NAV per share of the ETF, the market makers' risk of
loss increases. The greater the risk of loss, the more the market
makers will seek to cover that risk by quoting wider price spreads of
the proposed ETFs. This would result in market prices, at which
investors would buy and sell the ETF shares, not being at or close to
the NAV per share of the ETF, which would be contrary to the
foundational principle underlying section 22(d) and rule 22c-1 under
the Act that shareholders be treated equitably.
---------------------------------------------------------------------------

\60\ Commission staff met with market makers invited by the
Applicants on January 23, 2014.
\61\ ETF market makers commonly use representative hedging
portfolios instead of trading in basket securities because they may
be easier to implement or more cost effective. They do this to
offset market exposures as they build short or long positions in the
ETFs intraday. The market maker will earn profits to the extent its
hedge portfolio deviates from the NAV per share. See Gastineau March
2014 Letter, supra note 22, at 6.
---------------------------------------------------------------------------

42. The Commission preliminarily believes that, even under normal
market conditions, market makers could be unable to deconstruct the
portfolio holdings of a proposed ETF with sufficient accuracy in order
to construct a hedge portfolio that is closely aligned to the NAV per
share of the ETF. The proposed disclosures by the Applicants would
likely be useful in narrowing down the pool of securities and other

[[Page 63971]]

assets that may be held by the ETF, but only to a limited extent. For
example, prospectus disclosures of general risks and investment
objectives provide little quantitative precision about an ETF's assets
and risk exposures. The proposed quarterly portfolio disclosures would
provide little additional quantitative precision as a result of
portfolio turnover, as discussed previously. Consequently, variability
would inevitably be introduced into the proposed model. The Commission
believes that this may lead to a break in alignment between a market
maker's hedge portfolio and the NAV per share of the ETF; this could
diminish the market maker's ability to manage its risks, which, in
turn, could increase its risk of loss.\62\ This greater risk of loss
would be reflected in wider bid/ask spreads and result in intraday
market prices that deviate from the NAV per share of the ETF, which
would be contrary to the foundational principle underlying section
22(d) and rule 22c-1 under the Act that shareholders be treated
equitably.
---------------------------------------------------------------------------

\62\ See Examining the Exchange-Traded Nature of Exchange-Traded
Funds, Morningstar ETF Research (Feb. 11, 2013) (``Morningstar ETF
Report''), at 21 (``To consider conducting an arbitrage transaction,
arbitrageurs must be fairly confident that they will receive a
return commensurate with the level of risk they are assuming.
Therefore, it is likely that intraday changes to volatility (that
is, risk) cause arbitrageurs to become more or less confident when
transacting in the equity market for purposes of arbitrage and thus
cause premiums or discounts to occur in the short term. . . . From
the perspective of an arbitrageur, increased equity market
volatility implies that the value of purchased equities relative to
the value of the ETF's shares is at greater risk to fall and thus
increases the potential that arbitrage trade will be less
profitable, if at all. Therefore, when equity market volatility
rises, it is likely that an arbitrageur would wait longer before
acting to exploit an ETF premium. As a result, the ETF market price
would outperform the NAV price on days when equity market volatility
is increasing. . . . Arbitrageurs knowingly leave profits on the
table for a short amount of time because the risk or cost to trade
and profit is too high at that time.'').
---------------------------------------------------------------------------

43. The Commission also preliminarily believes that this potential
price disparity could be even worse under times of market stress or
volatility. Market makers would likely be heavily reliant on
sophisticated algorithms to deconstruct the portfolio holdings of the
proposed ETF in order to construct the hedge portfolio. During times of
market stress or volatility, the Commission believes that reliance on
these algorithms would not be sufficient for market making purposes in
the proposed ETFs and the correspondence between the hedge portfolio
and the NAV per share of the ETF might be expected to lag. This is
because the market makers' hedge portfolio may deviate significantly
from the actual portfolio of the proposed ETF, resulting in greater
intraday market risk to the market maker and a corresponding widening
of the bid/ask spread.\63\ This would result in market prices, at which
investors would buy and sell the ETF shares, not being at or close to
the NAV per share of the ETF, which would be contrary to the
foundational principle underlying section 22(d) and rule 22c-1 under
the Act that shareholders be treated equitably. Accordingly, although
some market makers supporting Applicants noted that they should be able
to construct hedge portfolios that were closely aligned (and would
remain aligned) to the NAV per share of the ETF for the domestic equity
ETFs proposed by Applicants, the Commission cannot fully agree with
that conclusion.
---------------------------------------------------------------------------

\63\ Ron Delegge, ETF Bid/Ask Spreads (Apr. 23, 2013), available
at http://investius.com/2013/04/23/etf-bidask-spreads/.
---------------------------------------------------------------------------

44. Finally, although Applicants proposed a retail redemption
option to address a significant and persistent deviation of market
price to NAV, as discussed in detail above, the Commission
preliminarily believes that this option is not sufficient to protect
investors as required by the Act.

B. Potential Disruption of Orderly Trading and Damage to Market
Confidence

45. In the absence of sufficient information for market makers to
accurately assess the value of the underlying portfolio securities and
to make markets in ETF shares at levels that are closely aligned to the
NAV per share of the ETF, market makers are likely to trade in proposed
ETFs with wide bid/ask spreads and variable premiums/discounts to the
NAV per share of the ETF. This would be particularly the case during
times of market stress and for active management strategies that might
involve high portfolio turnover when there is a greater need for
confidence in pricing signals.\64\ Under particularly stressful or
volatile market conditions, the inability to independently and
accurately value an ETF's portfolio assets may cause market makers to
withdraw from providing meaningful liquidity, which in turn can lead to
the disruption of orderly trading in the ETF.\65\ The Commission
preliminarily believes that a structure that may lead market makers to
make markets in the proposed ETFs at prices that are not closely
aligned to the NAV per share of the ETF is not necessary or appropriate
in the public interest, nor is it consistent with the protection of
investors or with the foundational principle underlying section 22(d)
and rule 22c-1 under the Act that shareholders be treated equitably.
---------------------------------------------------------------------------

\64\ See supra note 50 and accompanying text.
\65\ See Flash Crash Report, supra note 51, at 4-6. See also
Morningstar ETF Report, supra note 62.
---------------------------------------------------------------------------

46. Further, any breakdown in the pricing or the ability to price
the proposed ETF may result in damage to market confidence in secondary
trading of ETFs--not just in the proposed product, but in ETFs
generally. Investors may exit the ETF market because of a loss of
trust, particularly in actively managed ETFs, should the proposed ETFs
fail to function in a manner similar to current ETFs.\66\ For this
additional reason, the Commission preliminarily believes that it is not
necessary or appropriate, nor in the public interest or consistent with
the protection of investors and the purposes fairly intended by the
policy and provisions of the Act, to grant the requested relief.
---------------------------------------------------------------------------

\66\ See Tamar Frankel, Regulation and Investors' Trust in the
Securities Markets, 68 Brook. L. Rev. 439 (2002), at 448 (arguing
that once investors' trust is lost, they will flee the stock markets
and turn to other types of investments that ``they can see, evaluate
and guard for themselves.'').
---------------------------------------------------------------------------

* * * * *
47. In light of the foregoing, the Commission remains unconvinced
that Applicants' proposed ETFs meet the standard for relief under
section 6(c) of the Act. Accordingly, absent a request for a hearing
that is granted by the Commission, the Commission intends to deny
Applicants' request for an exemption under section 6(c) of the Act as
not necessary or appropriate in the public interest and as not
consistent with the protection of investors and the purposes fairly
intended by the policy and provisions of the Act.

By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-25438 Filed 10-24-14; 8:45 am]
BILLING CODE 8011-01-P