From: Kriya, Inc.
Date: January 8thth 2002
To: Jonathan G Katz
Secretary
SEC
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Comments to SEC Concept Release
Actively Managed Exchange-Traded Funds
Release No. IC-25258
Our Ref: SECETF01

EXECUTIVE SUMMARY

Comments have been added with respect to the SEC's request for public comments on the issues related to the successful launch of actively managed exchange-traded funds. Details of Kriya Inc. and a proof of how risklessness can be obtained in the limit for a market neutral hedge fund are obtained are detailed in the document.

Kriya, Inc., is a Texas based company and a leader in the application of nonlinear technology in financial-economics. Kriya's comments to Concept release IC-25258 embrace nonlinear technology to answer a market problem - the efficient use of assets. Efficiency in portfolio allocation, the Capital Asset Pricing Model, was illustrated by William Sharpe of Stanford and was the basis for his Nobel Prize in Economics. Franco Modigliani of Princeton also illustrated efficiency in corporate capital structure and this was the basis for his Nobel Prize. Efficiency may be thought of as a higher return per unit of risk. The concept of efficiency is analogous to gas mileage in vehicles where a greater miles per gallon is pursued. This is a marked change from a `faster' vehicle or in the financial world `making the highest return'.

The deliberate pursuit of efficiency is at philosophical odds with traditional approaches which pursue return and then attempt to contain risk. Conversely Kriya's view is that return is a function of risk management.

Extant `linear' based mathematics upon which the predominant interpretation of financial-economics is based has done a poor job of enumerating risk - arguably the other side of the coin of return.

Adopting a `market neutral' approach and actively trading the equities of the S&P 500 Index is Kriya's answer. Modern Portfolio Theory of the 1970's equates the expected return of a fully hedged equity portfolio to a T-Bill. If the return is fixed then so must the risk. By manipulating the equities with in the S&P 500 Index using advanced nonlinear technology Kriya is able to maintain the risk profile and enhance the return. The effect is to shift the Efficient Frontier closer to the origin when viewed in mean-volatility space as shown in Figure 1.0.

Figure 1.0 The Enhanced Efficiency Effect of a Market-Neutral Approach

In historical simulations in the 1990s & 2000s Kriya has been able to achieve approximately the returns of the S&P 500 Index with a considerably reduced volatility and daily value at risk (dVaR). This represents a significant technological break though.

AREAS FOR COMMENT

  • How are actively managed ETFs likely to be structured, managed and operated?

    An actively managed ETF in terms of investment structure could take any number of different forms, depending on the market for such a product. As in the actively managed fund sector, there is a vast range of different styles for the underlying markets such as traditional investments -equities and fixed-income and alternative investments such as -actively managed foreign exchange, interest rates futures, commodities, options, etc. There are also a variety of management styles which includes systematic, i.e. primarily managed by computer, discretionary, i.e. fundamental analysis coupled with human decision making and hybrids of the two. There is also management philosophy (absolute value, trend following, arbitrage, hedged etc.) and a variety of issues surrounding leverage which depend on the risk and return requirements of the investor.

    Investors require a large range of product choice to be able to construct portfolios around individual requirements. Of primary interest in constructing a portfolio is the concept of indexing (to measure manager performance), absolute return value (where the investment is a stand alone investment, uncorrelated to any benchmark) and correlation (in general it is desirable to have a basket of investments, some of which will be negatively correlated to benchmarks such as the S&P500 Index during bear markets and times of turbulence).

    These requirements will be met by the proper introduction of exchange-traded funds and will be a positive step forward for the investment community, leading to greater hedging opportunities, freedom of choice and overall reduction of portfolio risk.

    In terms of management and operation, there is not much of a difference between how an ETF is managed for passive or active sectors. Management of the fund is undertaken by the manager as set out in the risk disclosure document or offering memoranda and daily NAV is calculated so that the trading price of the ETF can be established.

    Extra risks will enter the equation once markets become actively managed. Adequate risk disclosure material as described below will thus be necessary to inform the investor of any additional potential risks involved.

  • How will investors use, and benefit from, actively managed ETFs?

    Investors may require an actively managed hedged equity product for two reasons, a) to gain a higher return whilst for comparable risk and volatility levels to a benchmark index (e.g. S&P 500 Index and b) for diversification purposes to lower the overall risk or volatility of the investor's portfolio.

    Investors will be able to obtain the past history (either actual or hypothetical) for the actively managed ETF investment and use this to calculate any potential benefits for the addition of this type of investment to their portfolio using modern portfolio theory.

  • Would the exemptive relief that the Commission has granted to index-based ETFs be appropriate for actively managed ETFs?

    Yes and will most probably have to be extended for actively managed funds require a) fee structure, b) leverage and c) disclosure.

    a) It is normal that index fund managers are limited to 1% of assets under management under the 40 Act as they are simply replicating a "dumb" passive strategy. Active managers however need to be recompensed for additional added value and cost of operation. This is usually done by the use of an "incentive fee" which is defined in the risk disclosure document as being a certain percentage i.e. 20% of net new profits where "New Net Profits" will be the excess, if any, of Cumulative Net Profits at the end of the month over the highest past monthly value of Cumulative Net Profits and where the "Cumulative Profit (Loss) from Trading" will be determined by totaling all the monthly amounts of "Profit (Loss) from Trading" since the inception of the fund and "Cumulative Net Profits" will be "Cumulative Profit (Loss) from Trading" minus Management Fees paid and accrued to date.

    b) It may be necessary to seek exemptive relief from Reg. T, which limits companies to a 2:1 or 50% leverage. For market neutral hedge funds for example, it may be necessary to leverage 3:1 in order to gear the returns so that they outperform the S&P 500 index benchmark whilst giving at least similar if not reduced volatility. If this is not done, product acceptance will be severely limited since equity investors are driven by performance relative to a performance benchmark such as the S&P 500 index.

    For Kriya specifically, leverage will be used to make the expected returns of their YEST (Yield Enhanced Synthetic T-Bill) product greater than the benchmark i.e. the S&P500. This stands to reason, as the portfolio is balanced in terms of its overall direction by definition of market neutrality versus the S&P500. Using no leverage will indeed reduce the YEST overall volatility considerably compared to the S&P500 but will also reduce returns (to approach the T-bill rate in theory) by about half.

    The market for the YEST however is composed of investors seeking a higher return than the S&P500 benchmark, with similar volatility. Hence, each side of the YEST must be leveraged to bring the total portfolio volatility of returns into line with the S&P500. In simulations, it has been shown that a leverage factor of two to three times may be necessary.

    It must be borne in mind, that leverage of three times using a properly defined market neutral/volatility neutral hedge fund composed of several hundred liquid equities is NOT the same as an outright long only position in the S&P500 leveraged three times. In fact, if a leveraging factor of three is required to bring the volatility of the YEST into line with the S&P500, then in theory this is the same as NO leverage applied to the S&P500 Index.

    Leverage will be achieved by the use of collateralized funding through the prime broker trading facility.

    Whilst other risks may of course exist due to leveraging, these should be clearly set out in any accompanying risk disclosure material.

    c) By definition, active management demands some proprietary leeway to both incentivize current and future technological development and to prevent `free riding'. The question of the Commission is one of balance between the agency costs of the fund of reporting and the contemplated arbitrage opportunities between the current ETF share price in the market and the fund's NAV created by the delay in reporting the fund's contents.

    REMEDY: Kriya proposes a 90-day delay in reporting the fund's contents. Since trades rarely exceed a 90-day duration the proprietary information of the fund manager is protected. The arbitrage opportunities are made adequate by the historical primacy of the quarterly reporting used by public companies and accepted by the investing public as an acceptable standard.

  • Are there any new regulatory concerns that might arise in connection with actively managed ETFs?

    Depends upon the risk to which the assets are exposed.

    Actively managed futures funds and managed accounts in the US have been effectively regulated by the CFTC through such government agencies as the National Futures Association (NFA). The SEC for the actively managed ETF sector may require a similar model. It has been effectively demonstrated by the on-going regulatory success of the NFA that by the obligatory use of standard Risk Disclosure Documentation, exam passing requirements for all associated persons, periodic ethics training, coupled with effective law enforcement, arbitration and an agency composed of a representative cross-section of industry delegates voted in on a regular basis leads to a minimum risk of incorrect marketing to the general public. In such documentation the notion of risk must be clearly enumerated along side that of potential profit, and every document used for marketing must first be signed off by a compliance department review committee. Performance must be updated every nine months at least in disclosure material and the disclaimer "PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS" must be clearly marked in bold visible letters for any publicly disseminated material. Hypothetical results used for marketing must be clearly marked to be as such and additional disclosure is required. The FBI screens applications for the suitable license to check for criminal records relating to the principals and associated persons.

    A similar approach may be required of the SEC regarding actively managed ETFs as the risks posed may be effectively equivalent to futures and options trading due to the actively managed aspect coupled with the possibility of leveraging achieved through collateralized funding on margin. Conversely a market neutral approach, with a lower risk, may require no additional regulation since the burden of oversight is shifted to the manager and is understandable to the market and the regulator.

  • Index-Based ETFs vs. Actively Managed ETFs

    Some actively managed ETFs will be benchmark-like and others will be unrelated to any benchmark. It will be up to the investor to decide which strategy is fits his / her needs. There is not necessarily any less risk in an actively managed ETF that is not benchmark related - it is simply less transparent and more difficult for the investor to see where the returns are coming from.

    These days benchmarking has become very important to institutional investors and it is imagined that any actively managed ETF that is not benchmark related may not have a sufficient market to become a viable product.

    The SEC could try different levels of regulation depending on the classification of the fund (market neutral, long/short, long only, short only, benchmark related, benchmark unrelated etc.). For example, a market neutral hedge fund may have less regulation requirements than a non-benchmark, long/short fund due to less inherent risk as a consequence of its market neutrality.

  • Operational Issues Relating to Actively Managed ETFs

  • Transparency of an ETF's Portfolio
  • Depending on the management technique, some funds may or may not be required to be transparent. If the purpose of the fund was to provide a widely accepted and publicly available method of benchmark enhancement for example, then the fund's contents should be made transparent on a daily basis. This would however lead to "free riding" and could lead to less liquidity and market for the ETF. However, the costs and difficulties related to free riding might be offset by the ease of use, respectability of management and low commissions associated with the ETF.

    On the other hand, some managers that use proprietary investment techniques coupled with expensive technology should not be required to make the portfolio contents transparent. That the Kriya YEST product if accepted, would make the contents of its portfolio public on a trailing 90 days basis, as most trades in the portfolio will have changed during the previous 90 days. This would circumvent the possibility of "free riding". This disclosure would be better than what some major funds do such as Janus, Fidelity and Vanguard who only release data on a semi-annual and annual basis. They don't even release quartely data to services like Lipper & Morningstar.

  • Liquidity of Securities in an ETF's Portfolio
  • Liquidity risk should be one of the risks clearly described in any accompanying risk disclosure documentation and is a "must have" for any investor so he can decide whether the risk is worth taking or not visa vie the underlying securities in the actively managed portfolio.

    The Kriya YEST product does not suffer from liquidity risk as it is confined to the S&P500 basket of equities, all of which have considerable liquidity.

  • Other Operational Issues
  • Additional operational risks can be set out in the appropriate risk documentation.

    Lower costs, liquidity and simplicity have driven the mass acceptance of ETFs since their inception in 1993. Simplicity includes lack of inefficient and unnecessary regulation.

    Market neutral strategies continue the theme of simplicity with a simple operational definition and places the onus of risk management on the manger, not on the investor or regulator.

    It is thought that the role played by specialists in institutionalizing and educating clients will lessen with wider product acceptance.

    For actively managed ETFs, no future versus index arbitrage is possible however arbitrage between the daily fund NAV and market price is possible.

    MARKET NEUTRALITY, DOLLAR NEUTRALITY AND VOLATILITY NEUTRALITY

    Market neutrality encompasses both dollar neutrality and volatility neutrality. Dollar neutrality is defined as a portfolio in which both long and short sides have a dollar equivalent weighting of stocks. Volatility Neutrality however is when both the long and short sides of the portfolio are balanced in terms of volatility, which whilst being a market neutral strategy is not dollar neutrality. A simple example should suffice to explain the difference between these terms.

    Imagine the simplest case where the market neutral hedge fund manager has to construct a market neutral portfolio from two stocks A and B, has $100M of committed funds and forecasts that stock A will rise (hence he will long to benefit) over the next period and stock B will fall (hence he will short to benefit).

    Stock Price per share (USD) Volatility (% p.a.)

    A

    1 20

    B

    100 10

    Market Neutral Strategy A - Dollar Neutral

    In this case, each side of the portfolio should be allocated half of the committed funds - $50M. The manager will then long 50M/1 = 50M shares of A and short 50M/100 = 500,000 shares of B.

    Market Neutral Strategy B - Volatility Neutral

    In this case, the objective of the manager is to have a volatility balanced market neutral strategy which will probably not correspond to case A above, as the two stocks have different levels of volatility associated with them.

    The manager will then long:

    Shares of A = $33.3M

    and short:

    Shares of B = $66.6M

    It can be seen that for strategy B, the final market neutral portfolio is less riskier than for strategy A, even though there are different amounts of funds invested on both sides. This is because case B equalizes the volatility or risk associated with each of the stocks. In the same way, a volatility neutral hedge fund can be constructed from any number of long and short forecasts.

  • Uses, Benefits and Risks of Actively Managed ETFs

    As mentioned above, there will be a high acceptance and potential benefit to investors with the introduction of actively managed ETFs.

    Investors will use actively managed ETFs to decrease their overall portfolio risk through diversification. The problem with even a diversified basket of index based ETFs is that most global indices have become and will continue to be highly correlated. During turbulent periods and bear markets, it is not possible to achieve stability of returns and performance with just diversification.

    This will be the true value and benefit of a properly managed active strategy - it provides effective shelter or negative correlation during turbulent periods when combined with indexes in a portfolio. If the investor forecasts a turbulent period ahead, additional units of an actively managed strategy can be bought as a form of risk management.

    The risks associated with active strategies can be dealt with using standard risk disclosure documentation.

    PROPOSED MARKET

    Kriya urges careful consideration of all applications for actively managed ETFs by the Commission since the proposed market that Kriya seeks to serve is the predicament of the G7 written domestically. It is envisaged that the most receptive part of the market for YEST will include pension funds. Why? As market conditions weaken, previously defined benefit 401(k) s must deliver a fixed return. Typically this return has been funded by investment performance. In the absence of investment performance, corporate earnings must meet the defined benefits. A weak market adversely affects investment and corporate performance simultaneously. Even a switch to defined contribution plans will not be sufficient to offset the weaker market.

    The demographics facing the G7 are common in the sense that an increasingly long-lived and ageing workforce is making a demand upon retirement plans that was not actuarially envisaged or politically alterable. Kriya's technology is applicable in any of the world's liquid equity markets. Should the Commission approve Kriya's approach, it is reasonable to expect that its actions will set a precedent for the G7.

    How will the proposals of the active managers deal with portfolio risk?

    Kriya considers this the most important question posed by the Commission. To date, the conventional aspects of risk-management have been limited to the linear mathematics upon which those assumptions are incorrectly based. For example, assessing the probabilities of future events has been dominated by such techniques as Monte-Carlo simulation. Although widely accepted, much recent work casts a shadow on the technique's most commonly used assumptions of; 1) normally distributed returns (e.g., returns that follow a Gaussian or Bell-shaped curve) and 2) randomness in time-series (e.g., a Brownian motion).

    The science of complexity theory has conclusively proved that; 1) returns have fat-tails, which indicate drastic events, like catastrophes, are much more probable than the risk-management software assumes and 2) financial-time series, as evidenced by the Hurst Exponent, first published in the literature by Benoit Mandelbrot of Yale in1963 are quasi-random. In short those time-series are partially predictable, at least in terms of their volatility.

    Current nonlinear techniques have been made `tractable' (i.e. computationally efficient in terms of processing cost and time) with the progress of processor clock-speed technology (Moore's Law) and the development of the underlying mathematics in chaos theory and critical phenomenon studies.

    Kriya proposes that a `market neutral' approach is the most beneficial for several reasons:

    1) To date the ETFs have involved de minimus risk products tracking an index or exposure to a country. To preserve and nurture a new venue for investing argues for a measured response towards increased risk. Normally an investment manager only faces the hazard of losing one's job and her investors' money. In the instant case, a failure in a new venue could retard the acceptance of the new venue of AM ETFs and thus financial innovation.

    2) This measured response is also mandated by the unavailability of SEC resources to actively monitor a potentially limitless number of strategies and to devise appropriate regulatory standards.

    MARKET NEUTRAL

    Kriya proposes a two-part test for the accepted definition of `market neutrality.' First, and lesser of the two-part test, is dollar neutrality. Dollar neutral is defined as long and short positions being dollar equivalent. The efficacy of dollar neutrality can be severely mitigated depending upon the market's instruments. For example in the NASDAQ bubble of the late 1990s several investors thought they were `hedged' by being long a dollar of IBM and short a dollar of EBAY. Of course, not only did EBAY have a smaller float, making it more susceptible to short squeezes but the inherent error was to assume that a mature company has similar `dynamics' to a young and rapidly growing one.

    The second and stricter part of the neutrality test, is volatility neutrality. Volatility neutrality is defined as the magnitude and duration of future movements in the long positions being equal but opposite to those in the short positions. This standard is difficult to achieve in reality (as the volatilities of the underlying equities are not a constant measurable not predictable process over time) so a compromise is proposed of plus or minus 25% of a relevant index, like the S&P 500 Index.

    Thus to be declared market neutral for the purposed of AM ETFs means at a minimum: 1) dollar neutral and 2) plus or minus the volatility of the relevant index.

    In reality volatility neutrality in the limit when both the short and long sides of the market neutral portfolio have equal volatility and are negatively correlated at the same time is impossible to achieve ex-ante, but demonstrates nonetheless how risk can be reduced via the market-neutral strategy proposed by Kriya.

    MARKET NEUTRALITY, DOLLAR NEUTRALITY AND VOLATILITY NEUTRALITY

    Market neutrality encompasses both dollar neutrality and volatility neutrality. Dollar neutrality is defined as a portfolio in which both long and short sides have a dollar equivalent weighting of stocks. Volatility Neutrality however is when both the long and short sides of the portfolio are balanced in terms of volatility, which whilst being a market neutral strategy is not dollar neutrality. A simple example should suffice to explain the difference between these terms.

    Imagine the simplest case where the market neutral hedge fund manager has to construct a market neutral portfolio from two stocks A and B, has $100M of committed funds and forecasts that stock A will rise (hence he will long to benefit) over the next period and stock B will fall (hence he will short to benefit).

    Stock Price per share (USD) Volatility (% p.a.)

    A

    1 20

    B

    100 10

    Market Neutral Strategy A - Dollar Neutral

    In this case, each side of the portfolio should be allocated half of the committed funds - $50M. The manager will then long 50M/1 = 50M shares of A and short 50M/100 = 500,000 shares of B.

    Market Neutral Strategy B - Volatility Neutral

    In this case, the objective of the manager is to have a volatility balanced market neutral strategy which will probably not correspond to case A above, as the two stocks have different levels of volatility associated with them.

    The manager will then long:

    Shares of A = $33.3M

    and short:

    Shares of B = $66.6M

    It can be seen that for strategy B, the final market neutral portfolio is less riskier than for strategy A, even though there are different amounts of funds invested on both sides. This is because case B equalizes the volatility or risk associated with each of the stocks. In the same way, a volatility neutral hedge fund can be constructed from any number of long and short forecasts.