January 11, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Actively Managed Exchange-Traded Funds Concept Release - File No. S7-20-01
Dear Mr. Katz:
Barclays Global Investors, N.A. ("BGI")1 is writing to respond to the Commission's request for comment on the Actively Managed Exchange-Traded Funds Concept Release (the "Concept Release").2 Exchange Traded Funds ("ETFs") are becoming increasingly popular investment alternatives for both institutional and retail investors. We appreciate the Commission's willingness to seek comment on the important issues raised by the potential introduction of a new and different type of exchange-traded product: the actively managed ETF. While BGI supports expanding the range of available ETF products, we are concerned that actively managed ETFs, depending on their structure, raise potential investor protection concerns not raised by traditional ETFs, including the possibility that retail shareholders may buy or sell shares in the secondary market at prices that do not reflect the value of the fund's underlying securities. We recommend that the Commission carefully consider these concerns when determining whether to grant exemptive relief to these products.
In drafting our response, we have focused on three issues highlighted by the Concept Release: (i) the relationship between the transparency of ETF portfolio holdings, arbitrage and secondary market trading, (ii) the potential benefits and risks to retail shareholders, and (iii) the potential for investor confusion. These issues and our comments are discussed in more detail below.3
I. Portfolio Transparency, Arbitrage and Secondary Market Trading.
The exemptive orders granted to existing ETFs are based upon the premise that the structure of traditional ETFs promotes efficient arbitrage and that because of these arbitrage opportunities investors should be able to transact in the secondary market at prices that approximate net asset value ("NAV"). It is generally accepted that portfolio transparency is the key to effective arbitrage. Therefore, the most significant issue for the Commission to consider in determining whether to grant exemptive relief to actively managed products is whether such products will provide the necessary level and frequency of portfolio disclosure to support efficient arbitrage. 4 As the Concept Release recognizes, the portfolio holdings of traditional ETFs are highly transparent. Transparency is a fundamental characteristic of traditional ETFs and transparency facilitates the arbitrage mechanism inherent in the traditional ETF structure. Because of this structure, arbitrageurs and other market participants can quickly and efficiently take advantage of arbitrage opportunities and shares of traditional ETFs generally trade in the secondary market at prices that track the NAV of the ETF's underlying portfolio. Actively managed ETF's may be reluctant to fully disclose their portfolio holdings and, therefore, actively managed ETFs may not be transparent. Any lack of transparency increases the cost and risk of arbitrage transactions and disrupts the arbitrage mechanism. As discussed more fully below, this raises significant investor protection concerns because it is questionable whether non-transparent products will support the efficient arbitrage mechanism necessary to reasonably assure that fund shares trade at prices that track NAV.
Traditional index-based ETFs are structured and designed with an efficient arbitrage mechanism that helps them closely track their NAVs. A key feature of the arbitrage mechanism is portfolio transparency.5 Traditional ETFs are "transparent": the content of their portfolios is disclosed on a daily basis through the publication of Portfolio Deposit/Redemption Baskets ("Baskets") that are identical or substantially identical to their actual portfolio holdings throughout the day.6 The transparency of traditional ETFs' portfolio holdings allows arbitrageurs and other institutional investors to determine the value of an ETF's portfolio relative to its per share trading price and permits arbitrageurs and institutional investors to take advantage of arbitrage opportunities.7 This tends to ensure that ETF shares trade in the secondary market at prices at or near NAV and at prices that reflect the value of the ETF's underlying portfolio.
We believe that any lack of portfolio transparency will impede the efficiency of this arbitrage mechanism. For example, to the extent arbitrageurs lack information about the contents of a fund's portfolio, the costs and risks of engaging in arbitrage transactions will increase, and they may be reluctant or unable to arbitrage fund shares. Similarly, to the extent specialists and market makers lack information about a fund's portfolio they will increase the spread between the bid and offer price on ETF shares, making it more likely that such shares will trade at a premium or discount. Lack of information about the fund's portfolio increases the likelihood that the spread between NAV and market price will persist. In addition, a large factor in the success of traditional ETFs is due to the ability of institutional investors, such as market makers and specialists, to use ETFs to hedge intraday trading risks. These investors will be less inclined to engage in such transactions if they are not confident that an ETF's Basket is identical or substantially identical to its portfolio holdings. The net result of these factors is a decrease in the efficiency of the arbitrage mechanism. This, in turn, increases the risks to investors by, among other things, increasing the risk that shares will trade in the secondary market at significant and recurring premiums or discounts. In addition to trading at significant premiums and discounts, there is a real possibility, as the Concept Release seems to recognize, that the secondary market trading price of a non-transparent product might not reflect the value of its underlying portfolio.8 This would be unlikely to occur with a traditionally structured ETF since its portfolio holdings are disclosed and investors can assess the impact of market conditions on its portfolio throughout the trading day.9
The Concept Release also asks whether an investment adviser to an actively managed ETF might face a conflict between maximizing performance and facilitating arbitrage through disclosure of portfolio holdings. We believe that any ETF that is not fully transparent would face potential conflicts of interest between the goals of maximizing performance and facilitating arbitrage. We believe these potential conflicts would be magnified in ETFs organized as classes of traditional mutual funds (since the interests of one class could conflict with the interests of others) and during periods of market volatility.
II. Potential Uses, Benefits and Risks of Actively Managed ETFs.
The Concept Release asks whether actively managed ETFs would appeal to retail or institutional investors and asks for comment on the principal uses, benefits and risks of actively managed ETFs. We believe that actively managed ETFs likely will be of far more interest to retail than institutional investors. Institutional investors typically do not use active mutual fund products for hedging, cash equitization or other strategies because they have access to lower cost, more flexible, customized alternatives and, for the same reasons, may have less interest in actively managed ETFs.10 Retail investors would likely invest in actively managed ETFs for many of the same reasons they invest in traditional actively managed funds and for some of the same reasons they invest in traditional ETFs.
An important benefit of traditional ETFs is that their shares can be traded throughout the day at prices that track NAV and closely correspond to the value of the ETF's portfolio securities. To the extent an actively managed ETF's portfolio is not transparent, we are concerned that retail investors will derive little benefit from the ability to trade such shares intraday, and, under certain circumstances, may be disadvantaged. As discussed, we believe that any lack of transparency negatively impacts the ETF arbitrage mechanism, which is likely to result in shares trading at secondary market prices that do not reflect the value of the fund's underlying portfolio. This is more likely to occur during periods of market volatility. Under these circumstances, it is not unreasonable to assume that some retail investors would buy or sell ETF shares at secondary market prices moving in the opposite direction of a fund's NAV.11 We believe the Commission should carefully consider these concerns in determining whether to grant exemptive relief to any products that are less than fully transparent and, at a minimum, should require prominent disclosure of these risks.
III. Potential For Investor Confusion.
As discussed above, traditional ETFs are designed and operated to promote efficient arbitrage. An efficient arbitrage mechanism is a defining characteristic of traditional ETFs and portfolio transparency is critical to this mechanism. We believe that ETF products that are not fully transparent will have inefficient arbitrage mechanisms and, because of this, will be significantly more likely than traditional ETFs to trade at prices that do not track NAV or otherwise closely correspond to the fair value of their underlying portfolios. Thus, to the extent the Commission grants exemptive relief to an actively managed product that is not fully transparent, we believe it is important for investors, particularly retail investors, to be aware that the arbitrage mechanism applicable to such products operates differently than the mechanism applicable to traditional ETFs, and that such products may expose investors to increased risks. We suggest that retail investors will be most protected and most likely to understand the differences between these two types of products if the Commission prohibits partially-transparent products from marketing themselves as ETFs. At the very least, we suggest that such partially-transparent products should be required to furnish investors with prominent disclosure that highlights these risks and notes the differences between these products and traditional ETFs.
* * * * * * * * * * *
Conclusion and Recommendation. We continue to support fully transparent ETF products (whether index-based or actively managed) that have efficient arbitrage mechanisms. The trading history of traditional ETFs indicates that transparency facilitates efficient arbitrage and that the arbitrage opportunities created by the design of traditional ETFs ensure that ETF shares generally trade at, or very close to, NAV. However, we are concerned that actively managed products that are not fully transparent will lack the efficient arbitrage mechanisms necessary to reasonably ensure that their shares will trade throughout the day at prices that track NAV. We believe that such products raise significant investor protection concerns and the Commission should carefully consider whether these concerns outweigh the potential benefits of these products.
We hope our comments have been helpful. If you have any questions, please contact the undersigned at (415) 597-2779 or Anne Barr at (415) 597-2790.
Very truly yours,
Richard F. Morris
Richard F. Morris
|1||BGI is the world's largest institutional investment manager, and the world's largest provider of structured investment strategies such as indexing, tactical asset allocation, and quantitative active strategies. As of December 31, 2001, BGI managed over $800 billion in assets for nearly 2,000 clients in 37 countries around the world. BGI has 2,000 employees worldwide and is owned by Barclays PLC, one of the UK's largest companies, and one of the world's leading global financial services providers. BGI is the parent company of Barclays Global Fund Advisors, the investment adviser to the iShares family of exchange-traded funds.|
|2||SEC Release No. IC-25258 (November 8, 2001), 66 Fed. Reg. 575614 (Nov. 15, 2001).|
|3|| Since actively managed products are still being developed, it is not clear exactly how they will be structured. As this is made clearer, either through the exemptive application process or otherwise, additional issues may arise that require further consideration and comment.
|4||The answer to this question is critical because to the extent that a product can not reasonably assure that its secondary market trading price will approximate the value of its underlying securities it would not appear to meet the definition of a "redeemable security" under section 2(a)(32) of the Investment Company Act of 1940 (the "Act") or the definition of "open-end company" under section 5(a)(1) of the Act.|
|5||Other important features of the traditional ETF design are (i) the fact that such products are based on indexes whose component securities are widely known, and (ii) the publication of an intra-day "proxy" for NAV which help retail investors assess the reasonableness of secondary market trading prices.|
|6||The operation and trading history of traditional ETFs indicates that in order for the Basket and portfolio to be considered "substantially identical" the portion of the ETF's portfolio that is not in the Basket should not have more than a negligible impact on the performance of the Fund.|
|7||A recent research report published by Prudential Securities Incorporated noted, in part: "When the prices and net asset values of an ETF's underlying securities are publicly visible and can be freely purchased in the open market, on the occasion when there is a disparity between market price and NAV the anomaly (advantage) can be identified essentially as soon as it begins to occur. Arbitrageurs can then buy or sell shares to capture the opportunity spread that has been (usually briefly) created by the pricing versus net asset value anomaly, quickly and efficiently narrowing/equalizing the spread between NAV and market price." Prudential Securities Incorporated, Exchange-Traded Index Funds Industry Primer, July 9, 2001.|
|8||The Concept Release notes that "[o]ne potential difference between the existing ETFs and an actively managed ETF is that, in the latter case, significant deviations might develop between the market price and the NAV of the ETF shares. It might also be possible that, during any particular time, the NAV of an actively managed ETF could be increasing while the market price of its shares could be falling, and vice versa." 66 Fed. Reg. 575614.|
|9||Premiums or discounts on transparent ETFs are typically based on factors known to market participants, primarily the costs of assembling Baskets, and other factors, such as non-synchronous trading between shares of the ETF and the underlying portfolio securities. (For example, ETFs based on non-U.S. indices may trade throughout the day when the market for the underlying securities is closed. ETF shares prices may diverge from NAV to reflect price discovery and the flow of information while the U.S. market is open and the foreign market is closed.) Because the portfolio holdings of a transparent ETF are visible to the public and because the factors affecting the value of such securities and the costs of assembling a Basket are known to the market, the trading price of ETF shares typically moves in step with the value of its underlying portfolio (although there may still be some slight premium or discount). Since it is not clear how market participants could analyze the impact of market events on the undisclosed portion of a non-transparent product, we believe there is a very real possibility that such products could trade at prices that do not reflect, and may be moving in the opposite direction of, the value of the fund's underlying portfolio.|
|10||Institutional investors would be even less likely to use an actively managed product that was not fully transparent because of the potential increased costs and risks of such products, as discussed in Section I herein.|
|11||As discussed in Section I above.|