Speech by SEC Staff:
Remarks Before the 4th Annual Art of Indexing Summit
by
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Washington, D.C.
September 20, 2006
I. Introduction
Good morning. It is a pleasure to be here today among so many luminaries from the exchange traded funds and index investing arena. I am pleased that one of my first major addresses as Director of the Division of Investment Management is taking place in this forum focused on exchange traded funds, which have become an increasingly popular and important investment vehicle for America's investors.
The first exchange traded fund was launched in 1993. Thirteen years later ETFs have $337 billion in assets, have become a staple of discussion in the financial press and have assumed an established place in the lexicon of American investors — both individuals and institutions. I recently read about a new retail newsletter that reports on exchange traded funds, and of course ETFs are frequently featured in the financial sections of many newspapers and finance magazines. In addition, many market analysts track and report on ETFs. Needless to say, ETFs have become a significant, mainstream component of the financial marketplace.
In speaking with you this morning, I have been asked to discuss our thoughts regarding ways to improve the review process for new ETFs coming to the market. Before I address that important issue, however, I need to state clearly that my remarks here today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
II. The ETF Landscape
When I arrived at the SEC on May 15th of this year, I was greeted by an intelligent and dedicated staff, a Chairman and Commissioners with a genuine interest in investment management issues and a cadre of fellow Division Directors who had exchanged the private sector lifestyle for the opportunity to engage in meaningful public service. I was also greeted with the news that many people felt that the SEC and the Division of Investment Management were moving too slowly in our review of new exchange-traded funds, and that we needed to do more to facilitate the introduction of ETFs. In fact, in June, one month after my arrival, the Wall Street Journal published an article about ETFs entitled "Growth of Hot Investment Tool Slowed by Bureaucratic Backlog." Of course, the following month, the Wall Street Journal published another article about ETFs, this time entitled "Surge in ETFs Could Diminish Their Appeal." What a difference a month can make!
Contradictory press reports aside, it seemed obvious that we needed to take a closer look at our ETF review process, and I am pleased to report that we are currently in the midst of a concerted effort to evaluate and improve our process for reviewing ETF proposals. My staff and I, as well as Chairman Cox and the other Commissioners, are committed to ensuring that proposals to introduce ETFs are reviewed and considered in an efficient manner with an appropriate level of staff analysis.
Before I look forward, however, let me begin with a review of what has happened in the ETF marketplace so far this year. At the beginning of this year, there were, according to Investment Company Institute statistics, 201 ETFs with $296 billion in assets. Six months later, on June 30, 2006, there were 263 ETFs with a total of $335 billion in assets. To my staff's knowledge, no ETFs were liquidated in the first six months of 2006, though historically there have been several ETF liquidations. This means that during the first six months of 2006, 62 ETFs were introduced (a 31% increase in the number of ETFs) and assets increased by $39 billion (a 13% increase). Based on press reports and the number of recently filed ETF registration statements, we expect that these numbers will continue to increase significantly during the remainder of the year.
So how do the SEC and the Division of Investment Management even get involved in the introduction of ETFs to the markets? The process can be somewhat complex and multi-faceted, and can depend significantly on the proposed structure of the product. For example, some people consider ETFs to include the various commodity and currency trusts that have been introduced in the past year. These products are actually not registered investment companies, and the Division of Corporation Finance assumes the primary role in their review. In addition, regardless of whether the product is structured as a commodity or currency trust or as a registered investment company, the Division of Market Regulation likely will be involved in issues related to the listing and trading of the products on national securities exchanges.
The Division of Investment Management takes a leading role in reviewing the proposals to introduce ETFs that are registered investment companies. As you may know, the Investment Company Act of 1940 regulates the operations of investment companies, but generally only provides for types of investment companies like mutual funds and closed-end funds. ETFs were not envisioned when Congress drafted the Investment Company Act, and not surprisingly they do not fall neatly within any of the traditional categories of investment companies.
As a result, when investment advisers want to introduce ETFs, they submit applications to the SEC seeking certain exemptions from the Investment Company Act to permit the operations of the ETFs. The Commission is authorized to grant such exemptions, but it must find that granting the exemptive order is in the public interest and consistent with the protection of investors and the purposes of the Investment Company Act.
The application process historically has been a time-consuming one. Staff attorneys in the Division review the submissions, and then work with the applicants and their counsel to address any issues presented by the filings. This process can entail several rounds of comments and responses. If an ETF proposal is novel, we present the matter to the Commission to consider and authorize any action. When we are finished with our review, we generally publish a notice of the application in the Federal Register, and then issue an order granting the exemptions if we do not receive any hearing requests during the notice period.
We have been especially busy reviewing ETF applications this year, and we have issued five ETF orders in the past few months. In May, we issued an order to Van Eck Associates to permit the introduction of the Gold Miners ETF. In June, the Commission issued an order to ProShares to introduce so-called leveraged ETFs — the first ETFs to seek a multiple or inverse multiple of the return of various indices. Also in June, the Commission issued orders to WisdomTree Investments to introduce the first ETFs based on affiliated indices and to Barclays to introduce additional fixed-income ETFs. On Monday of this week, we issued an order to Claymore Advisors to permit the operations of their new group of ETFs.
III. Improving the ETF Review Process
As the interest in ETFs has increased, naturally so has the number of ETF applications submitted to the Commission. As a result, even though we've been issuing ETF orders at a record pace in the past few months, we've also received a record number of ETF proposals, which leaves us with a significant number of pending ETF applications. So while you are thinking creatively about the types of indices and ETFs to develop, we are trying to think creatively about ways in which we can improve our ETF review process in light of our significant experience with the exemptive relief necessary to permit ETF operations, as well as the increasing demand for ETFs by investors. This morning, I'd like to mention a few of the measures that the Division is undertaking or considering to prioritize and streamline the review of applications to introduce ETFs.
Earlier this year, the Division of Investment Management, at both a staff and supervisory level, began a targeted focus on what we consider to be routine index ETF applications. The staff is prioritizing the review of these types of applications as "time sensitive," especially in light of the fact that an ETF, unlike applicants for many other types of exemptive relief, cannot commence any operations prior to the receipt of an exemptive order. Some of the regulatory developments that I mentioned are the early results of this focus, and I expect that you will see additional tangible results in the coming months, as more orders for routine ETF applications are issued.
In addition, the staff in the Division of Investment Management is considering the merits of a new approach toward ETF review that would de-emphasize our focus on the securities indices underlying ETFs. Part of the staff's typical analysis of ETF exemptive applications has been to examine the pricing, liquidity and other characteristics of the securities in an index underlying an ETF in order to assess whether the ETF would operate in a manner consistent with existing ETFs, including allowing for an efficient arbitrage process that would keep the market prices of the ETF shares close to the NAV of those shares.
As the staff has monitored developments and operations in the ETF marketplace, it appears that the basic ETF structure has functioned as designed for index-based ETFs, notwithstanding differences in the characteristics of index securities. As a result of our administrative experience with ETFs and their operational success in the marketplace, I believe that our review process should become more streamlined, particularly in terms of our analysis of the underlying markets upon which the ETFs are based. As a result, for applications that propose ETF operations similar or identical to the ETF operations normally described for index-based ETFs, we are considering streamlining our comment process on the applications to ensure structural consistency among the products, but to reduce the staff's scrutiny of the underlying securities markets.
The staff is also considering the merits of expanding the future relief contained in ETF orders, which permits ETF sponsors to introduce similar ETFs without going through the exemptive applications process a second time. While we are still considering the ways in which this future relief could be formulated, we think that such a development could result in fewer applications from the same ETF groups. Again, this is just one of the many ideas under consideration, and one that we will develop in conjunction with our colleagues from other Divisions and with the Commission itself.
Perhaps the most significant initiative that I wish to mention today is that our staff is beginning to develop a proposal for an ETF rule under the Investment Company Act. As you may recall, once upon a time, the Division was swamped with exemptive applications to introduce another popular type of investment company that required exemptions from the Act — the money market fund. The Commission ultimately adopted rule 2a-7 under the Act to permit money market funds to operate without seeking individual exemptive orders from the Commission. An ETF rule could serve a similar function by permitting new ETFs to come to market without having to first obtain an exemptive order. As the staff envisions such a rule, it would need to be appropriately tailored to those types of ETFs with which we have substantial experience, most likely routine index based ETFs. While the idea for an ETF rule has been mentioned from time to time over the years, we have previously questioned whether the evolving nature of the ETF marketplace lent itself to rule standardization. However, the number of new routine index-based ETF applications submitted this year has convinced us that there is value in focusing our limited resources on developing a proposal for an ETF exemptive rule.
The rule would be subject to the traditional rulemaking procedures of the issuance of a proposing release, opportunity for comment and, if the Commission so determines, adoption of a final rule. Obviously, if the Commission votes to propose an ETF exemptive rule, you in the audience today, including index providers, ETF sponsors and managers, and ETF investors, would be crucial constituencies in terms of providing feedback on the rule — hopefully telling us where we got it right, but also telling us where we should make adjustments.
IV. Actively Managed ETFs
In terms of novel ETF applications, certainly the affiliated index ETFs and leveraged ETFs approved this year represented new developments for ETF products, and the staff continues to be open to proposed ETF innovations. One area that has attracted much press relates to actively-managed ETFs. As many of you know, the Commission issued a concept release on actively-managed ETFs in November 2001 — nearly five years ago — in order to gain a broader understanding of some of the issues that might be implicated by proposals for actively managed ETFs. The dialogue on actively managed ETFs has continued since then, and we have received some applications for actively managed ETFs, but, as you well know, no actively managed ETF has been approved or launched.
One issue we need to tackle with respect to active management of ETFs is transparency. Transparency, to date, has been a hallmark of ETFs, and much of the efficient trading in ETF shares has been attributed to the high degree of transparency in ETF portfolios. However, many portfolio managers of actively managed funds will tell you that too much transparency can diminish the manager's ability to deliver positive performance because it may telegraph the manager's moves to the marketplace. In the context of proposals for actively managed ETFs, we likely will be called upon to assess the extent to which transparency is critical to the ETF structure, and to make recommendations to the Commission as to how this issue should be addressed.
Another issue we must keep in mind as we move down the spectrum toward active management of ETFs is that ETF investors are no longer limited to institutions. Individual investors represent a significant percentage of the buyers of ETF shares in the secondary market — I have seen estimates as high as 70%. As we entertain proposals for actively managed ETFs, it will be important for us to keep in mind the changing nature of the ETF investor base and the ways in which the new ETFs could differ from the standard ETF structure. The staff is working on this issue, and I fully expect that you will continue to see evolution in the ETF marketplace during my tenure as Division Director. I look forward to working with you on your innovations.
V. Improving Communications with Investment Management Staff
Having spent my 30-plus year career in the financial services industry on the outside of the SEC looking in, I can tell you that one can make some interesting observations when one finally gets a look behind the curtain. The first observation is that the staff is dedicated to moving along ETF applications, whether for routine, index-based ETFs or more novel products. These applications do not fall into a black hole — where some on the outside may perceive them to be. The staff is raising relevant issues internally, coordinating with each other to ensure consistency and conducting research to understand the legal and marketplace ramifications of the requested relief. Unfortunately, the nature of the internal review process means that much of this focus and effort is not visible to ETF applicants and the investing public.
Even so, I have directed our applications review staff to work to improve communications with applicants for exemptive relief, including ETF applicants. I believe that periodic updates on the status of the staff's review and the identification of the name and telephone number of a person that an applicant can call to check on an application are two simple steps we can take to promote better communication between our applicants and our staff.
Applicants deserve to know the status of their applications and to have a point of contact to find out information about the staff's review. In addition, I encourage applicants to be up front in terms of communications with our staff. If you have two exemptive applications pending, but one of them is more significant because of your business needs, please tell us that. Our staff, where possible and appropriate, will consider your needs in its review and prioritization of applications. I want to make sure that our systems of communication are effective.
VI. Disclosure Initiative
Moving beyond the staff's process for reviewing and processing ETF applications, I would like to discuss another major initiative that we are focused on at the SEC. We are in the midst of a wholesale review of the investment company disclosure regime — which includes a review of ETF disclosure.
As you may be aware, many ETFs have obtained exemptive relief from the Commission so that dealers may effect secondary market transactions in ETF shares without providing a prospectus under certain circumstances. As a condition to this relief, each listing exchange has adopted rules requiring the delivery of a "product description" instead of a prospectus for these ETFs. A product description is a brief document that presents an overview of the ETF, including a description of the ETF's investment objective and strategies, and the material risks and potential rewards of owning the ETF shares, as well as information on how to obtain a prospectus.
In connection with our disclosure reform initiative, I am interested in your views of the utility of those product descriptions. In particular, I would like to know whether, based on your experiences, the product descriptions provide helpful and meaningful disclosure to investors and whether it would be beneficial for the SEC to incorporate this type of a disclosure requirement for other products purchased in the secondary, or even primary, market.
As we conduct our review of the fund disclosure regime, I am also interested in your views of whether ETFs necessitate specialized disclosure requirements — different than those applicable to typical mutual funds or closed end funds — because of the unique structure of ETFs.
I would also like to hear your thoughts about how ETFs should be presented to investors in light of the evolution of the ETF marketplace. For example, early ETFs tracked major broad-based indices and often were essentially viewed as efficient ways to trade index securities during the day through one trade instead of hundreds of trades. By contrast, today there is significant variation in ETF offerings. Some ETFs are based on very specific sector indices, while other ETFs track indices that are more performance-oriented. Some ETFs may be appropriate for long-term investors as part of an asset allocation strategy, while other ETFs may cater to investors with short-term hedging goals. The variation in indices can also lead to variations in investor benefits. For example, ETFs based on indices that rebalance frequently may be less tax efficient than ETFs tracking indices with less turnover. The performance of a narrow index may be more volatile than the performance of a broad-based index. Communicating these types of differences to investors can obviously be very important, and I am interested in your ideas about ways to ensure that investors know what they are buying.
VII. Conclusion
In conclusion, I certainly do not want my staff or my Division to be an unnecessary impediment to new product development or marketplace innovation. I think we all can agree that investors generally benefit from responsible product innovations. I am committed to improving the ETF approval process, and Chairman Cox has identified the efficient processing of ETF applications as one of his priorities. This issue is receiving focus from the most senior levels at the SEC.
As I have stated, in the case of index-based ETFs, where we have 13 years of experience with the products' operations and investment attributes, I believe it is appropriate for the staff to consider revising and updating the regulatory scrutiny it brings to bear. When reviewing applications for ETFs, our staff should work in the most meaningful way possible by streamlining the review of standard ETF applications and targeting its energy, effort and expertise on the more novel proposals. I believe that this approach will ultimately provide the greatest benefit to our nation's investors.
With respect to innovations to the ETF structure, including the issue of active management, I believe this is a step that must be taken with thoughtful consideration and responsible review of the potential implications for investors and the marketplace.
ETFs have had tremendous success, and investor demand and enthusiasm for them have grown significantly in recent years. I encourage ETF sponsors, managers and distributors to embrace responsible business practices, which will serve to earn the continued acceptance and respect of mainstream American investors. When developing products, you should consider not only whether it is legal and will sell, but also whether it will benefit investors. And I encourage investors to ask questions and understand their ETF investments before handing over their hard-earned investment dollars.
Thank you again for inviting me here today.
Endnotes
http://www.sec.gov/news/speech/2006/spch092006.htm
