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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Regulatory Issues Involving Exchange Traded Funds


Paul F. Roye

Director, Division of Investment Management
U.S. Securities and Exchange Commission

American Stock Exchange Symposium on Exchange Traded Funds

New York, New York
January 14, 2002

I. Introduction

It is my pleasure to be here this morning to participate in this Symposium on Exchange Traded Funds. I thank the American Stock Exchange for the invitation to express my views, which as a matter of Commission policy I must emphasize are my own and do not necessarily reflect the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

Exchange traded funds are one of the more interesting categories of products that the Commission regulates in the Investment Management area. In recent years, exchange traded funds have been characterized by dramatic growth and exciting prospects. In the past three years, assets in U.S. exchange traded funds have grown from just over $15 billion to nearly $80 billion. As of the end of November, there were 101 exchange traded funds listed in the United States, up from just 29 three years ago.

Prospects for future growth of exchange traded funds seem to abound. While institutional investors have been particularly interested in exchange traded funds, interest appears to be growing among retail investors as well. Recently-introduced wrap account products may filter more retail investors into exchange traded funds. Exchange traded fund sponsors reportedly are also looking into making exchange traded funds available to 401(k) accounts, and last Friday's Wall Street Journal reported that many investment advisory and brokerage firms are developing all-ETF portfolios for their clients.

In addition, retail mutual funds are starting to invest in exchange traded funds, and several mutual funds have been organized to invest primarily in exchange traded funds. Exchange traded funds, once seen by some in the mutual fund industry as a threat to business, are slowly being embraced by traditional funds. Not only are some mutual funds beginning to invest in exchange traded funds, but one of the largest mutual fund sponsors has introduced a class of exchange traded shares. In another sign of exchange traded funds' acceptance by the traditional mutual fund industry, the Investment Company Institute, the mutual fund industry's trade association, now tracks and publishes data about exchange traded funds. Some industry observers have even predicted that the popularity of exchange traded funds, and their low expense ratios, may result in downward pressure on the fees charged by traditional mutual funds.

Exchange traded fund growth may also result from possible evolution of types of exchange traded funds. All of the current exchange traded funds track equity market indices, such as SPDRs (S&P 500), Diamonds (Dow Jones Industrial Average) and QQQs or Cubes (Nasdaq 100). We have received applications for exchange traded funds that would track fixed income indices and an application for exchange traded funds that would track indices of ADRs. We also have received applications for exchange traded funds that we would consider to be actively managed.

Exchange traded funds are trading on new exchanges. In July of 2001, exchange traded funds began trading on the New York Stock Exchange, and it is reported that the Nasdaq is developing, and plans to list, an exchange traded fund based on its Nasdaq composite index. U.S. exchange traded funds are even trading overseas, with several U.S. exchange traded funds trading on the Singapore Exchange.

There seem to be significant prospects for exchange traded fund growth outside the borders of the United States. Sixty-one new exchange traded funds were introduced in Europe last year. In the third quarter of 2001, European exchange traded fund assets grew 58% to over $3.6 billion. Exchanges in Canada, Hong Kong and Japan also launched new exchange traded funds. Recent reports indicate that approximately half of all exchange traded funds are located outside the United States and that exchange traded fund assets have increased by 43 percent worldwide since the beginning of last year. I believe that the final panel today will discuss exchange traded funds from a global perspective, in view of the popularity of exchange traded funds throughout the world.

As exchange traded funds have grown and evolved, the Commission and its staff have worked with the sponsors of these funds to foster innovation while maintaining investor protections. Today, I plan to speak about the history of exchange traded fund growth and development. I then will review the four main phases of regulation of exchange traded funds by the Commission (the exemptive application process; approval of the listing of an exchange traded fund; registration of a fund's shares and review of its prospectus disclosure; and compliance inspections). Finally, I will discuss some novel exchange traded funds that we are currently reviewing and discuss the Commission's recent concept release on actively managed exchange traded funds.

II. Exemptions

The exchange traded fund industry began in earnest with the launch of SPDRs in 1993. Prior to launch, SPDRs received a Commission order providing a series of exemptions from certain provisions of the Investment Company Act. Exchange traded funds are registered as investment companies under the Act, which regulates open-end funds, closed end funds and unit investment trusts or UITs. As you know, exchange traded funds are hybrid products. Like an open-end fund, exchange traded funds issue redeemable shares at net asset value or NAV. However, those shares can only be issued or redeemed in large creation units. Like a closed end fund or a stock, the individual shares of exchange traded funds trade in the secondary market at negotiated prices. Investors can also sell those shares short or purchase them on margin. Because exchange traded funds are not typical mutual funds, they do not fit perfectly into the Investment Company Act's regulatory regime. In order to operate as designed, exchange traded funds must receive an order from the Commission exempting the funds from various provisions of the Act.

A. Exemptive Order Process

In order to obtain an exemptive order from the Commission, an exchange traded fund and its sponsor must file an application explaining the basis and legal rationale for the requested exemptions. Following submission of an application, the staff reviews the application and works with the applicants to resolve regulatory issues. The staff then makes a recommendation to the Commission regarding whether to issue the order. In more routine cases, the staff may be able to issue the order under authority delegated by the Commission to the Division. Prior to issuing an order exempting an exchange traded fund from provisions of the Investment Company Act, the Commission must determine that the exemptions are in the public interest and consistent with the protection of investors and the purposes of the Act. The Commission also must issue a public notice of the application and give interested persons an opportunity to request a hearing.

B. Nature of Exemptions

Exchange traded funds typically obtain relief from three main provisions of the Investment Company Act. First, the Act requires that open-end investment companies, as well as unit investment trusts, issue shares that are redeemable by the fund. Because exchange traded fund shares are only redeemable in large creation units, the funds must obtain relief from the requirement that fund shares be individually redeemable. In supporting their request for this relief, exchange traded funds note that their shares are redeemable in large aggregations. They also note that shares on the secondary market typically trade at or near NAV because of arbitrage opportunities. Thus, investors in exchange traded funds generally should be able to sell their shares in the secondary market for a price at, or near, NAV-even if they cannot redeem individual shares directly from the fund.

The second area of exemptive relief enables the funds' shares to trade on an exchange at negotiated prices, rather than a price based on NAV, as required for traditional mutual funds.

The third area of exemptive relief allows for in-kind transactions between a fund and its affiliates. The Investment Company Act prohibits an affiliated person of a fund from selling any security to, or purchasing any security from, the fund. An affiliate includes any person who owns 5% or more of a fund's outstanding securities. Because the purchase and sale of creation units may be in-kind rather than cash transactions, and because some large shareholders of an exchange traded fund could own more than 5% of the fund's voting securities, the Act could prohibit large shareholders from purchasing or redeeming additional shares. Thus, exchange traded funds obtain exemptive relief to allow large shareholders to purchase and redeem shares through in-kind transactions.

In addition to these three principal areas of relief, certain exchange traded funds have also requested relief from the Act's prospectus delivery requirements when investors purchase fund shares in the secondary market. Under the relief granted, investors who purchase their fund shares in the secondary market generally receive a written "product description" discussing key characteristics of the fund. In requesting relief from the Act's prospectus delivery requirements for purchases on the secondary market, applicants note that, because the shares are exchange listed, a large amount of information is available about the shares. They also note that investors who purchase exchange traded fund shares directly from the fund still receive a prospectus and that investors who purchase in the secondary market can still obtain a prospectus upon request.

C. Organization

The organization of exchange traded funds has evolved over time. SPDRs and the first exchange traded funds were organized as unit investment trusts. UITs are trusts that issue undivided interests in a unit of specified securities, such as the securities making up the S&P 500. Currently, there are four exchange traded funds organized as UITs: SPDRs, Mid-cap SPDRs, Diamonds and Cubes.

Most exchange traded funds launched today are organized as open-end funds, the form of organization of a traditional mutual fund. The Commission first allowed exchange traded funds to organize as open-end funds in 1996. Exchange traded funds that are open-end funds can be formed as different series of a single trust or even as a different class of shares of an existing fund, as the Commission allowed with the Vanguard Vipers product.

Another significant feature of exchange traded funds organized as open-end funds is that, rather than holding securities that replicate an entire index, the fund could instead use "sampling techniques" to track the performance of an index. The ability to use "sampling techniques" is particularly significant for exchange traded funds that track foreign stock indices because certain foreign stocks in an index may pose issues with respect to liquidity, or possible foreign ownership restrictions. By "sampling" the stocks in an index, the exchange traded fund can seek to replicate the performance of the index without actually owning all the component stocks in the index. Open-end exchange traded funds also can employ options and futures in achieving their investment objective and can engage in securities lending transactions. Because there generally is more flexibility in an exchange traded fund organized as an open-end fund, 97 of the 101 exchange traded funds in existence as of November 30, 2001 were organized as open-end funds.

As I mentioned, the Commission also has allowed exchange traded funds to be organized as a separate class of shares of an existing index fund. In an order issued to the Vanguard Index Funds in December 2000, the Commission granted the standard exemptions as well as novel relief relating to certain provisions of the Act requiring that different classes of shares of the same fund have the same rights and obligations. Shares of an exchange traded class arguably have certain different rights from shares of a traditional mutual fund class. For example, shares of traditional mutual funds are individually redeemable from the fund, while shares of an exchange traded class are not individually redeemable. They can only be redeemed in large creation units. In addition, the exchange traded class' shares are traded on the secondary market, while the traditional mutual fund classes' shares are not.

In reviewing Vanguard's application for exchange traded classes of existing index funds, much of our concern focused on potential investor confusion. The fund agreed to take a variety of steps to ensure that investors understand the key differences between the exchange traded class and the traditional mutual fund classes. For example, the exchange traded shares are not marketed as a mutual fund investment and their marketing materials and prospectus clearly state that the exchange traded shares are not individually redeemable from the fund. In addition, Vanguard agreed to refer to the exchange traded class by a different trade name, "VIPERS."

So far, the Vanguard order is the only one allowing an exchange traded fund to be organized as a separate class. However, we believe the Vanguard order provides a model for organizing an exchange traded fund as a separate class of shares of an existing index fund.

D. Prospective Relief

Traditionally, every new exchange traded fund was required to obtain an exemptive order from the Commission in order to operate. In May of 2000, however, the Commission issued the first exchange traded fund order granting prospective relief. The order, issued to the iShares Trust, stated that, if the iShares Trust lists a new exchange traded fund that is a series of the trust, the fund does not have to obtain an exemptive order, if the fund meets certain Commission-approved listing standards imposed by the exchange on which it is listing. As I will discuss shortly, these listing standards allow exchange traded funds to be listed without Commission approval of the specific listing.

Orders providing prospective relief are significant because they expedite the introduction of products when those products do not raise new issues. Relying on the prospective relief granted by the Commission, exchange traded fund sponsors may launch new exchange traded funds without obtaining an additional Commission exemptive order. I must note that the prospective relief applies only to the original parties to the exemptive order, and their future series. Thus, every new family of exchange traded funds must obtain an order. However, if they receive an order granting prospective relief, the family can then launch additional funds without obtaining additional orders, as long as the new exchange traded funds meet the generic listing standards and satisfy the terms and conditions of the original order.

In addition to providing prospective relief, the staff is considering whether additional growth in exchange traded funds would dictate that we recommend to the Commission that conditions of our orders in this area be codified into a rule. A rule would enable new exchange traded funds that meet the rule's conditions to be launched without obtaining an individual exemptive order.

III. Approval of Listing

One of the standard conditions of an exchange traded fund exemptive order is that the fund must be listed on a national securities exchange. When exchange traded funds were first developed, the national securities exchange on which an exchange traded fund wanted to list had to obtain Commission approval for each new product by making a filing with the Commission known as a 19b-4 filing, handled by our Division of Market Regulation. The Commission was required to provide notice to the public and an opportunity for comment prior to approving the listing.

In 1998, the Commission amended its rules to permit exchanges to list certain products meeting their listing standards, once the Commission has approved generic listing standards for that type of product. In 2000, the Commission approved listing standards for exchange traded funds submitted by the American Stock Exchange, thus permitting the Amex to list certain exchange traded funds that satisfy their generic listing standards, without the Commission having to approve listing standards for each exchange traded fund. This "fast track" listing authority is another example of the Commission allowing exchange traded funds to list and trade without the necessity of additional action by the Commission as the products become more mainstream and no longer pose novel investor protection issues.

IV. Review of Prospectus Disclosure of Exchange Traded Funds

In addition to obtaining an exemptive order and listing approval, exchange traded funds must register their securities and submit their prospectus for review prior to offering their securities. One of the most significant disclosure issues involving exchange traded funds came about in May 2000 when the Consumer Federation of America and Fund Democracy, a shareholder advocacy group, each filed a hearing request in response to the iShares Trust's notice of exemptive application. The CFA and Fund Democracy were concerned that the potential premiums and discounts to NAV of exchange traded funds were not properly disclosed.

In response to the request for a hearing, the iShares Trust added two additional conditions to their exemptive application stating that they would provide disclosure indicating how frequently a fund's shares traded at a premium or discount to NAV based on daily closing market prices and disclose the magnitude of those premiums and discounts. The fund's prospectus and annual report also must contain fund total return information based on both NAV and market price. All exchange traded funds that have obtained exemptive orders since May 2000 also have agreed to include these disclosures. Similarly, the NASDR, which regulates exchange traded fund advertising, has stated that exchange traded funds advertising fund performance must present two sets of performance numbers: one based on NAV and one based on market price.

V. Compliance Inspections and Examinations

Once an exchange traded fund has received an exemptive order, is listed on an exchange, has registered its securities, and has launched a sale of its shares, the fund continues to be subject to compliance inspections and examinations by SEC staff. In conducting inspections of exchange traded funds, our staff may focus on areas such as a fund's index tracking, a fund's deviation between market price and NAV, and the independence and oversight of a fund's board of directors. If exchange traded funds evolve to the point that they are based on actively managed portfolios, as opposed to portfolios tracking an index, our inspections of those exchange traded funds also would evolve. The inspections staff likely would focus more closely on portfolio management and portfolio trading issues, particularly in relation to disclosures of the portfolio and the portfolio management process.

VI. Fixed Income Exchange Traded Funds

Given the success of equity index exchange traded funds, there has been talk of developing exchange traded funds to track fixed income indices and developing actively managed exchange traded funds. We have received two applications for exchange traded funds that would track fixed income indices. Some of these indices would be comprised of Treasury securities; others would contain government agency securities and investment grade corporate bonds. The staff is working with the funds to address the issues presented by these products, including issues related to the liquidity of fixed income securities versus equity securities and issues associated with the creation and composition of fixed income creation units.

VII. Actively Managed Exchange Traded Funds

The Commission also has received two applications for funds that would use leverage to seek to achieve a multiple, or an inverse, of an equity index. The Commission and its staff have assumed that any exchange traded fund that would not seek to track the performance of a market index by either replicating or sampling the index securities in its portfolio would be an actively managed exchange traded fund.

In November, the Commission issued a concept release that outlines many of the unresolved issues surrounding actively managed exchange traded funds-both leveraged index funds and traditional actively managed portfolios. For example, it is not clear whether an actively managed exchange traded fund would propose to inform investors of the contents of its portfolio in the same manner as index-based exchange traded funds. Managers of actively managed funds generally avoid telegraphing their portfolio management movements, while, on the other hand, information about the contents of an index underlying an exchange traded fund is easily obtained. It is not clear how, or whether, an actively managed exchange traded fund would communicate intra-day changes in its portfolio to investors. This potential for less transparency in the portfolio holdings of an actively managed exchange traded fund could make the process of creating and redeeming creation units more difficult or present greater investment risk for arbitrageurs. As a result, an actively managed exchange traded fund could have a less efficient arbitrage mechanism than index-based exchange traded funds, which could lead to more significant premiums or discounts in the market price of its shares.

The agenda for today's Symposium states that the core attributes of any successful exchange traded fund are efficient pricing and liquidity. As sponsors develop actively managed exchange traded funds, they may wish to consider whether and to what extent these core attributes will be present. As the Commission reviews applications for exemptive orders for actively managed exchange traded funds, we must find that granting the exemptions is in the public interest and consistent with the protection of investors and the purposes of the Investment Company Act.

Comments on the Commission's concept release are due today. While the staff is reviewing the comments, we will continue to move forward with our analysis of the exchange traded fund applications that have been filed with us. As Chairman Pitt has stated, the Commission will not stand in the way of innovation. But we are committed to satisfying our mandate to protect investors, while at the same time working with you to bring new products to market.

VIII. Conclusion

Exchange traded funds were an innovative product when they were first introduced, and their growth and development have continued to be marked by innovation. We have seen changes in format and organization, changes in the types of indices underlying the funds and even a step away from the traditional index approach toward possible exchange traded funds with actively managed portfolios. As the products have evolved, the regulation of exchange traded funds also has evolved. Further, as the markets, investors and regulators have become more accustomed to exchange traded funds, comparable exchange traded funds are able to be introduced with less regulatory review prior to launch.

Assets continue to flow into exchange traded funds, and investors continue to praise these products for their tax efficiency, their liquidity, their modest fees and their ease of trading. It appears that the exchange traded fund segment of the fund industry can look forward to a bright future. Again, as Chairman Pitt has emphasized, we are committed to keeping pace with the future growth and development of exchange traded funds, while at the same time maintaining our resolve to protect America's investors.

Thank you for inviting me here today, and I look forward to a productive and informative Symposium.



Modified: 01/15/2002