National Association for Variable Annuities

From PLI’s Course Handbook

Nuts & Bolts of Financial Products 2010

#23341

Evolution of exchange traded products: how new sec rules may tip the competitive balance

W. Thomas Conner

Sutherland

This conference outline is intended for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making a decision or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland Asbill & Brennan and the recipient.

The author would like to express his gratitude to his colleague Eric Freed, who contributed to this outline.

I. Introduction

Exchange traded funds or “ETFs” are a relatively new type of investment vehicle. From an investment perspective, most ETFs function as index mutual funds. Unlike indexed-based mutual funds, however, ETF shares trade on an exchange and investors can buy and sell shares throughout the day at market determined prices. This feature, potentially greater transparency and liquidity than mutual funds, the opportunity for use in sophisticated trading and hedging strategies, and lower costs and certain tax advantages, have made ETFs more popular with some investors than conventional mutual funds.

These relative advantages have contributed to fast growth in the ETF market. By one estimate, since the first ETF was introduced in 1992, assets grew to $417 billion by year-end 2006. It took the U.S. mutual fund industry from 1924 to 1984 to grow to this level of assets.[1] By year-end 2008, the number of ETFs had grown to 728 and total assets had grown to $531 billion.[2]

ETFs are regulated like mutual funds under the federal securities laws, but their unique structural and operational characteristics require exemptions from the Securities and Exchange Commission (“SEC” or the “Commission”) that mutual funds do not need. At the end of the day though, forming, registering, and operating a conventional ETF is, at this point, relatively “old hat” from a regulatory standpoint.

Recent years have seen the development of a new type of exchange traded product that tracks the performance of specified commodities, currencies or other “hard assets.” This outline refers to these products as “exchange traded vehicles” (“ETVs”). Because ETVs invest in commodities, currencies, or other hard assets, they are not subject to the Investment Company Act of 1940 (the “1940 Act”), the special set of statutes and rules that govern mutual funds, ETFs, and other types of investment companies. However, ETVs are subject to the same registration requirements that apply to mutual funds, ETFs and other investment companies under the Securities Act of 1933 (the “1933 Act”), plus additional rules under the 1933 Act and the Securities Exchange Act of 1934 (the “1934 Act”) that do not apply to funds.

Yet another variation on the ETF theme is the “exchange traded note” or “ETN.” Like ETFs and ETVs, ETN shares trade in the secondary market and seek to provide investors returns based on underlying securities, commodities or other indexes. Importantly, however, ETNs do not seek to track the index by investing in the component securities or commodities comprising the index; rather, ETNs are notes constituting the general debt obligation of a bank issuer. Unlike conventional notes, however, ETNs do not promise the return of an investor’s principal at maturity. Instead, the amount due at maturity is determined by reference to the underlying index. This structural characteristic of ETNs is designed to eliminate the potential for tracking error inherent in ETFs and ETVs, but ETN investors are subject to the general credit risk of the issuer and there are potential tax issues.

This conference outline is being submitted in the beginning of December 2009, for a panel entitled “Exchange Traded Funds/Exchange Traded Notes” at the 2010 Nuts & Bolts of Financial Products Conference. It addresses the following topics:

· How will a recently proposed SEC rule change the regulatory landscape for ETFs?

· Will the rule permit ETF sponsors to register new ETFs and bring them to market more quickly and with less legal cost, and if so, when?

The answer to the second question is relatively straightforward – it’s “yes.” If the SEC adopts the rule changes as proposed, ETF sponsors generally may be able to register new ETFs and bring them to market more quickly and with less cost. However, recent speeches by senior SEC officials indicate the final adoption of the rule may not be as imminent as once thought.

The first question is more difficult to answer, but equally important. The exchange traded product industry now has three distinct dimensions – ETFs, ETVs, and ETNs. The SEC’s proposed rule changes would affect only ETFs, which leaves open the very significant question of whether and how the new rules will change the competitive dynamics between ETFs and the other two products.

This outline goes about answering the two questions by first explaining how each product is currently regulated and how associated costs and regulatory burdens impact the viability of each product. The outline then examines how the SEC rule initiatives may change the current competitive balance between these exchange traded products.

II. General Operation and Regulation of Exchange Traded Funds and exchange traded vehicles

A. Typical Operation of an ETF

Most ETFs are index funds. Their investment objective is to track the performance of a specified index, up or down, by investing in all, or a representative sample of, the component securities of the index. For example, the “SPDR” ETF invests in the stocks comprising the S&P 500 Composite Stock Price Index. There are also numerous sector-specific ETFs, ranging from industrials to health care and medical development, which track a variety of other market indices.

Because ETFs track indices, it is not surprising to find that most of the largest ETF sponsors are index specialists that consider ETFs a natural extension of their business. Some of the biggest ETF sponsors include Baclays Global Investors (iShares), State Street Global Advisors (SPDRs), Vanguard, Invesco Ltd (PowerShares), ProFunds, Security Benefit’s Rydex Investments, First Trust, and Claymore. The unique nature of the exchange traded products industry, however, has permitted the entrance of several ETF sponsors, like Wisdom Tree, that were not part of the “mainstream” mutual fund industry.

Although the exchange traded products industry until recently has enjoyed dramatic growth, we are now seeing some consolidation and restructuring in the industry that may impact competition among ETF sponsors in the future. There are also signs that the launching of new ETFs slowed down in 2008 compared with 2007, and the majority of newly introduced ETFs were currency and commodity-based ETVs.[3] 20009, however, has seen the introduction of a wide range of new ETFs, ETVs, and ETNs, although the recent financial crisis and resulting credit concerns may have decreased the popularity of ETNs, which as discussed below, subject holders to the general credit worthiness of the ETN issuer.

Unlike index and other mutual funds, ETFs do not sell shares to, or redeem shares from, individual investors at net asset value (“NAV”). Instead, ETFs sell and redeem their shares at NAV only in large blocks called “creation units” (such as 100,000 shares). Brokerage firms and institutional investors that purchase or redeem ETF shares in creation units (referred to as “Authorized Purchasers” or “APs”) typically do so through “in-kind” transactions involving a “portfolio deposit” equal in value to the aggregate NAV of the ETF shares in the respective creation unit. The ETF’s sponsor (typically the fund’s investment adviser) announces the contents of the portfolio deposit at the beginning of each business day. The portfolio deposit generally consists of a basket of securities that mirrors the composition of the ETF’s portfolio. Because the purchase price of the creation unit must equal the aggregate NAV of the underlying ETF shares, the requisite portfolio deposit generally also includes a small amount of cash to account for the difference between the market value of the deposit basket and the aggregate NAV of the ETF shares. The value of a creation unit typically exceeds several million dollars.

After purchasing a creation unit, the AP may hold the ETF shares, or sell some or all of the ETF shares to other brokerage firms, institutional investors, or individual investors. Thereafter, the shares are listed on a national stock exchange (such as the New York Stock Exchange) and trade through purchase and sale transactions in the secondary market, just like shares of stock of any public company, until such time as an Authorized Purchaser purchases the shares in the secondary market to sell them back to the ETF in a creation unit.

In this regard, ETFs possess characteristics of “closed-end” funds, which generally issue shares that trade at negotiated prices on national securities exchanges and are not redeemable. Like closed-end funds and conventional corporate issuers generally, in order for their shares to be traded in the secondary market, ETFs must list their shares for trading on a national securities exchange under the 1934 Act. As with any listed security, investors also may trade ETF shares in the secondary market in off-exchange transactions. In either case, ETF shares trade at negotiated prices determined by the demand and supply for the ETF shares and by the values of the securities in the ETF portfolio. The market price of ETF shares may be higher or lower than the NAV of the ETF shares. Such pricing discrepancies are more common for ETFs that do not trade as frequently, but all in all, most ETFs experience a price discrepancy of 1% or so, which is better than closed-end funds, which on average reportedly trade roughly 4% below the value of their holdings.[4]

The development of the secondary market in ETF shares depends upon the activities of the market makers assigned to make a market in the ETF shares and upon the willingness of Authorized Purchasers buying creation units to sell the corresponding ETF shares in the secondary market. ETF shares purchased in the secondary market are not redeemable with respect to the ETF itself except in creation units. If an Authorized Purchaser purchases enough shares of an ETF in the secondary market to make up a creation unit and presents this block of shares to the ETF for redemption, the AP receives a “redemption basket,” the contents of which are identified by the ETF sponsor at the beginning of every business day. The redemption basket (usually the same as the portfolio deposit) consists of securities and a small amount of cash. As with purchases from the ETF, redemptions are priced at NAV (i.e., the value of the redemption basket is equal to the NAV of the ETF shares sold back to the fund in the creation unit-sized block of shares). An investor holding fewer ETF shares than the amount needed to redeem a creation unit-sized block of shares may dispose of those ETF shares only by selling them in the secondary market. The investor receives market price for the ETF shares, but pays customary brokerage commissions on the sale and the purchase of ETF shares.

B. Regulation of ETFs under the Federal Securities Laws

Like index and other types of mutual funds, ETFs fall within the definition of an “investment company” under the 1940 Act and consequently are required to be registered with the SEC under the 1940 Act as “open-end management investment companies.”[5] (The term “open-end management investment company” is the technical reference for what we commonly think of as “mutual funds.”) As is also the case for index and other funds, ETFs are required to register their shares with the SEC in accordance with the registration provisions of the 1933 Act. As is the case for mutual funds generally, applicable exemptions save the ETF from having to file periodic reports such as 10-Ks and 10-Qs with the SEC as would otherwise be required by the 1934 Act. Instead, ETFs and mutual funds generally are required to provide investors with semi-annual and annual shareholder reports.

C. Benefits of Exchange Traded Funds

ETFs offer investors several important potential benefits. First, ETFs provide investors with the opportunity to invest in a diversified basket of securities through the purchase of a single exchange traded security. As a result, investors may obtain the diversification benefits of a mutual fund while still being able to trade the shares of the ETF with the flexibility of a listed stock. In addition, unlike closed-end funds (the traditional type of investment company that issues exchange traded shares), ETFs may avoid the discounts and premiums in market price often associated with closed-end fund shares by continuously issuing and redeeming ETF shares in creation units and thereby creating an arbitrage mechanism (discussed in more detail below).

1. ETFs as a Tool for Individual Investors

As the ETF marketplace has developed, individual investors have accepted ETFs as an index investment with trading flexibility. Certain individual investors invest in ETF shares as a long-term investment for asset allocation purposes, while others apparently trade ETF shares frequently as part of market timing investment strategies. For those investors who trade more frequently, ETFs offer the ability to purchase and sell ETF shares in the secondary market at a known price anytime during the trading day, to purchase ETF shares on margin, to sell ETF shares short and to sell futures and options contracts on ETFs.[6] Unlike mutual funds, ETFs provide full portfolio transparency by disclosing their portfolio holdings every day, while mutual funds disclose their portfolio holdings only four times a year with a 60-day delay.[7]