October 20, 2015
I answer only with regard to the following specific request for comment:
"We request comments on whether such flexibility [in determining the composition of redemption baskets and portfolio deposits] would result in favorable or unfavorable changes in how ETFs manage the liquidity of their holdings. For example, would ETFs benefit from reduced cash drag? Would the flexibility enable or encourage ETFs to reduce the overall liquidity of their portfolios or to hold a greater amount of relatively illiquid assets? Does the existing 15% guideline adequately address any concerns regarding liquidity that could result from greater basket flexibility? Would the requirements we are proposing adequately address any concerns regarding liquidity that could result from greater basket flexibility? If not, could other requirements adequately address any concerns?"
As a preliminary matter, I am not of the opinion that allowing exchange-traded funds (ETFs) some flexibility to deviate the composition of their redemption baskets and portfolio deposits from the underlying assets of the ETF would necessarily result in unfavorable changes to how ETFs manage the liquidity of their holdings. Whether or not such flexibility would create a favorable result in the management of portfolio liquidity is, however, more difficult to determine. This desire by ETF sponsors and managers is, of course, an extension of the continuing movement by many sponsors to offer less-transparent or non-transparent ETFs. Less transparency and, on the extreme, no transparency, would thus allow ETFs to engage in more active management of their portfolios rather than simply tracking an established (or self-created) index. Perhaps by looking only at the empirical data, one might deduce that active management is not the wholly preferred method of most ETFs, or most open-ended funds generally, as it is widely perceived in the industry that active management does not tend to "beat the market" as often as its proponents might hope. In fact, actively managed funds have consistently underperformed compared to their indexed brethren. Proponents of the opposing, but still widely held, belief that active management offers other substantial benefits to investors would argue otherwise.
But, to the credit of active managers, at least one study (by Sungarden Investment Research) suggests that, during periods of market decline (i.e., bear markets), active managers outperform around 75% of their indexed competitors. Bearing that notion in mind, it is understood that decreased transparency in ETFs might (1) reduce liquidity because authorized participants might be less likely to deal in such products, and (2) increase the premium/discount of the ETF shares in the secondary market due to greater difficulty in pricing the unknown assets of the ETF. But, if we assume that at least a handful of authorized participants would agree to deal in such a product, which would in turn allow for a market of sufficient liquidity to develop, that could arguably stabilize pricing with regard to the premiums/discounts. If the concern is that such products with less liquidity will be the first to be sold during periods of market decline, thus creating redemption issues if the underlying assets are less liquid and consequently dropping the price of those assets, then that concern should be alleviated, at least to some extent, by applying the above referenced study's conclusion that active managers outperform indexed funds during periods of market decline.
Without belaboring the issue, it is sufficient to conclude that allowing ETFs the flexibility to vary the composition of their redemption baskets and portfolio deposits would not, ipso facto, encourage or enable ETFs from reducing overall liquidity. While it is uncertain whether the existing 15% guideline, which has been in existence since 1992, adequately addresses all of the concerns of reduced liquidity that may arise from increased flexibility, it is likely sufficient for the time being to ensure that overall liquidity will not decrease substantially to the detriment of investors as a result of the increased flexibility. That assumption is buttressed more so by the proposed reporting and disclosure requirements that would require a fund to disclose its classification of asset liquidity and liquidity risk management practices, also newly required under this proposed rule.
Thus, I am of the opinion that, if and when the Commission finds it appropriate to do so, the combination of the 15% limit on illiquid assets and these proposed rules, if promulgated, would sufficiently meet the concerns (albeit not all the concerns) associated with the liquidity risks that may or may not result from allowing ETFs increased flexibility to determine the composition of portfolio deposits and redemption baskets.