Two International Place
Boston, MA 02110
January 14, 2002
Via Electronic Mail and Federal Express
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
Re: File No.: S7-20-01- Comments on Actively Managed Exchange-Traded Funds
Dear Mr. Katz:
State Street Bank and Trust Company ("State Street") welcomes this opportunity to comment on the U.S. Securities and Exchange Commission's (the "Commission") concept release regarding actively managed exchange-traded funds ("ETF")(the "Concept Release"). State Street has been a leader in the ETF marketplace since it partnered with the American Stock Exchange to launch the SPDR Trust, Series 1 in 1993. State Street believes that actively managed ETFs will be a valuable investment vehicle for both institutional and individual investors and encourages the SEC to grant the exemptive relief needed to facilitate the development of actively managed ETFs. The Concept Release identified a number of areas for which the Commission has requested comment. For purposes of our comments, we have followed the outline of the Concept Release and have identified in order those items for which our comments are intended to apply.
I. Executive Summary
A. Structure, Management and Operation of Actively Managed ETFs
We believe there are many potential product structures for actively managed ETFs. A key consideration will be the amount of portfolio disclosure in the actively managed ETF design. The management of actively managed ETFs, similar to traditional mutual funds, could vary greatly, depending on the design of the product and nature of the underlying investment objective of the actively managed ETF. The operations of an actively managed ETF will need to be developed and enhanced to support the product structure and investment management goal of the actively managed ETF.
B. Investor Use and Benefit
State Street believes that actively managed ETFs will be beneficial to investors in a number of situations. Actively managed ETFs could potentially serve as short-term or long-term trading vehicles, allow investors to gain exposure to an asset category in a manner similar to index-based ETFs and play a significant role in an investor's hedging strategies. State Street believes that like index-based ETFs, actively managed ETFs will appeal to both individual and institutional investors.
Similar to their index-based counterparts, State Street believes that the most important uses and benefits of actively managed ETFs will be their flexibility, tradability and tax efficiency. We also believe that actively managed ETFs provide investors with the ability to "trade the market" in one transaction. With traditional mutual funds, investors are forced to subscribe or redeem shares at unknown prices. In contrast, actively managed ETFs will trade on a stock exchange throughout the trading day. This will provide investors with more flexibility, and allow them to determine when they want to transact.
C. Exemptive Relief
As discussed below, State Street believes that the exemptive relief granted to existing index-based ETFs would be appropriate for actively managed ETFs. State Street anticipates that actively managed ETFs will operate in much the same way as index-based ETFs and require the same exemptive and no-action relief.
Further, we believe that the Commission should consider adopting rules to allow for the creation of ETFs without the need for exemptive relief. Although situations that require additional relief may arise, State Street believes that rulemaking would allow for more efficient creation of ETFs.
II. Index-Based ETFs vs. Actively Managed ETFs
In the Concept Release, the Commission asks if there is an appropriate way to distinguish between index-based and actively managed ETFs, and further if there are any reasons to distinguish between different types of actively managed ETFs. State Street believes that the differences between existing index-based ETFs and those actively managed ETFs that plan to maintain a similar level of transparency will not be significant. The more significant difference that could arise with actively managed ETFs is the level of portfolio transparency that is provided to the public. As discussed in greater detail below, those ETFs that propose to operate with less transparency than existing index-based ETFs would be required to add additional disclosure regarding the risks of investing in such a fund, including the possibility that such a fund may trade at discounts and premiums that are higher than those for fully transparent ETFs. The Commission may also wish to consider whether no-action relief from Section 16 of the Securities Exchange Act of 1934, as amended (the "Exchange Act") is appropriate for ETFs that propose to operate with less transparency than existing index-based ETFs.
III. Operational Issues Relating to Actively Managed ETFs
A. Importance of Arbitrage and Significance of Premium and Discounts
We believe that the ability to effectively arbitrage an ETF product is integral to the ETF trading at or close to fair value. An ETF structure that does not have an effective arbitrage mechanism could result in wider bid/ask spreads which, in turn, could lead to larger premiums and discounts to the underlying NAV of the ETF. While the importance of an effective arbitrage mechanism is clear, there are potential ways to achieve an effective arbitrage mechanism with less than full transparency, and, potentially, with no portfolio transparency. This may be accomplished with proper disclosure of an actively managed ETF's investment strategy and portfolio characteristics. Therefore, placing a requirement that a certain percentage of the portfolio of a particular fund be transparent, without taking into consideration other characteristics of its design, may be placing undue restrictions on the ETF.
In any and all cases, clear and detailed disclosure with respect to the ETF's portfolio transparency, arbitrage mechanism and the potential impact of the ETF trading at a premium/discount should be required disclosure.
B. Transparency of an ETF's Portfolio
To some degree actively managed ETFs exist today. Index ETFs whose portfolio is managed through a sampling technique, rather than the full replication of the index ("Sampled ETFs"), and which are currently registered with the SEC and trade on the AMEX could be considered actively managed ETFs. The portfolio holdings of a Sampled ETF generally do not fully replicate its underlying benchmark index. Instead, a Sampled ETF invests in a selection of the securities from the underlying index which it is tracking. With this in mind, one can argue that sampling in such a manner allows the asset manager to actively manage the ETF's holdings. For this reason, actively managed ETFs can be effectively categorized into two broad categories, "Transparent Actively Managed ETFs," which exist today in the form of sampled ETFs, and "Non-Transparent Actively Managed ETFs."
While some actively managed ETF investment managers may elect to fully disclose the contents of their portfolio holdings, other investment managers may not. The active ETF investment manager who does not desire full disclosure of his or her portfolio should have the option to enjoy the same portfolio disclosure requirements of existing actively managed open-end and/or closed-end funds.
Regardless of the extent of ETF portfolio disclosure, in order to avoid unfair advantage and artificially creating a separate class of ETF shares, the same portfolio disclosure must be made to all parties (i.e. market makers, brokers, retail and institutional investors, etc). Similar to an actively managed open-end fund, an actively managed ETF should have, at a minimum, the same requirements of portfolio disclosure. Keeping in mind, for the case of a transparent actively managed ETF, disclosure may be greater, more frequent, or may be fulfilled by providing a sample of the portfolio.
Greater portfolio disclosure of an ETF definitely aids in creating greater arbitrage opportunities, narrower bid/ask spread, and lower premiums and discounts. With that said, a non-transparent actively managed ETF will be no worse off than closed-end funds trading today. In fact, the premium/discount of a non-transparent ETF should be narrower due to the ETF's open-ended qualities. Because an open-end ETF allows daily redemptions and creation at NAV, the spread (and premium/discount) should be even narrower than that experienced by similar closed-end funds.
State Street does not believe that an investment manager of an actively managed ETF should be required to disclose intra-day changes in the portfolio. State Street does believe, however, that in the case of a material event, actively managed ETFs should be required to disclose changes similar to those required by other exchange listed entities.
Further, State Street does not believe that it would be necessary at this point to require the specified Creation or Redemption Basket to change during the day to reflect changes in the actively managed ETF's portfolio.
C. Liquidity of Securities in an ETF's Portfolio
State Street also believes that the market should be allowed to determine which funds will be successful and which will not be successful. We assert that funds whose investment objectives and strategies hinder the arbitrage process will trade at higher discounts and premiums and, as a result, may prove to be less successful than those with strategies which promote effective arbitrage.
In the Concept Release, the Commission questions whether an actively managed ETF should be permitted to invest in certain types of securities.1 State Street believes that actively managed ETFs should be treated in the same manner that actively managed open-end investment management companies are treated. We believe that portfolio managers need the flexibility to take advantage of a variety of investment vehicles in order to effectively meet their investment objectives.
Actively managed ETFs should be required to adhere to the Commission's policy requiring an open-end investment company to restrict investment in illiquid securities to 15% of the fund's total assets.2 We believe the investors in actively managed ETFs that invest in illiquid securities would be subjected to the same level of risk as those open-end mutual funds that invest in illiquid securities.
State Street further supports allowing actively managed ETFs to invest in securities that cannot be included in a Creation or Redemption Basket. Index-based ETFs currently accommodate investors with restricted securities in their standard Creation or Redemption Baskets by allowing custom baskets in which cash is substituted for the restricted securities. Index-based ETFs also currently have the flexibility to allow Creation or Redemption Baskets to vary from portfolio holdings and each other in certain situations. In addition to accommodating investors with restricted securities in their baskets, portfolio managers of actively managed ETFs may need to invest in certain other securities which may not be available for inclusion in Creation or Redemption Baskets. As a result, State Street anticipates that cash or other securities will be substituted for the unavailable securities in the same manner that index-based ETFs allow custom baskets.
We also believe that actively managed ETFs should also be permitted to invest in securities that are not registered under Section 12 of the Exchange Act. Currently, all "Authorized Participants," those parties that may purchase or redeem Creation Units, are "qualified institutional buyers." As such, each Authorized Participant may transact in securities that are not registered under Section 12. In the event that such securities are illiquid or otherwise unavailable for inclusion in a Creation Basket, cash or other securities may be substituted for the unavailable securities in the same manner as discussed above. State Street further asserts that actively managed ETFs should be permitted to invest in "unsold allotments" provided the fund does not violate Sections 12 and 17 of the Investment Company Act of 1940, as amended.
Although preferable, in-kind purchases and redemptions of Creation Units are not absolutely necessary. While cash purchases and redemptions of Creation Units could impact the funds by decreasing the tax efficiency, such use of cash for Creation Units may provide more efficient portfolio management in cases where illiquid securities are included in the fund's portfolio.
D. Other Operational Issues
In general, the operations of an actively managed ETF would work similar to existing index-based ETFs. Some potential challenges could be technology enhancement necessary to more frequently update portfolio information if that is a requirement of an active ETF. If significant deviations in market price and NAV of an active ETF did occur, we do not believe this would compromise the operations of the ETF.
IV. Uses, Benefits and Risks of ETFs
A. Uses and Benefits of Index-Based ETFs
The most important use and benefit of index-based ETFs is that they enable investors to gain almost instantaneous access (short or long) to the performance of various market indexes in a low cost and tax efficient manner. State Street believes that expense ratios have become increasingly important to both retail and institutional investors because they can have a significant impact on a fund's return and the investor's potential for wealth accumulation. Additionally, because redemptions and subscriptions occur in-kind and the cost of these transactions are borne by the subscribing or redeeming Participant, the costs of acquiring and or disposing of securities are less than a typical mutual fund. There are additional cost savings due to shareholder recordkeeping being maintained by Depository Trust Company.
ETFs provide investors with the ability to "trade the market" in one transaction. With traditional mutual funds, investors are forced to subscribe or redeem shares at unknown prices. In contrast, ETFs trade on a stock exchange throughout the trading day. This provides investors with more flexibility and allows them to determine when they want to transact.
Index funds generally offer greater tax benefits than their active fund counterparts because they typically generate fewer capital gains due to lower portfolio turnover. Indexed mutual funds, however, may be forced to realize capital gains as a result of shareholder redemptions. On the other hand, because ETFs trade on an exchange, most shareholder activity is the result of matching buyers and sellers, versus trading activity in the underlying portfolio. This results in greater tax efficiency because the portfolio is not impacted by the shareholder activity that occurs on the exchange.
B. ETFs Problems, Confusion and Undesirable Consequences
We believe that the introduction of ETFs have had a positive impact on the Capital Markets, in general, as they have made available to all investors (institutional, retail, buy and hold and active traders) an efficient mechanism for gaining instant access, either long-term for buy and hold investors or short-term for active traders, to broad segments of the Capital Markets. This mechanism has helped to "level the playing field" between retail and institutional investors as both have access to the benefits of ETFs described above.
While investor education and proper disclosure in ETF prospectuses and fund literature have contributed significantly to ensuring that investors understand the differences between traditional mutual funds and ETFs, any future mandates to support actively managed ETFs should continue this education and disclosure effort.
C. ETFs and Market Volatility
We believe that ETFs impact market volatility in a similar way that derivatives impact market volatility. Arguments are made that because ETFs and derivatives facilitate the trading of an underlying basket of securities, they may increase market volatility in periods of market uncertainty as investors may use these vehicles as a means for communicating their views on the current market. We believe this use of ETFs, as well as the use of derivatives, at times of market volatility will help to facilitate price discovery in the marketplace.
D. Desirability and Potential Benefits of Actively Managed ETFs
Similar to their index-based counterparts, State Street believes that the most important uses and benefits of actively managed ETFs will be their flexibility, tradability and tax efficiency. Because we envision that redemptions and subscriptions will occur primarily in-kind, there will be fewer internal costs associated with operating an ETF versus a typical actively managed open-end mutual fund. Essentially, the commissions and other related expenses that mutual funds pay to buy and sell securities triggered by shareholder activity will also be greatly reduced in an actively managed ETF.
Similar to index-based ETFs, actively managed ETFs also provide investors with the ability to "trade the market" in one transaction. With traditional mutual funds, investors are forced to subscribe or redeem shares at unknown prices. In contrast, actively managed ETFs will trade on a stock exchange throughout the trading day. This will provide investors with more flexibility, and allow them to determine when they want to transact.
Again, because ETFs trade on an exchange, most shareholder activity is the result of matching buyers and sellers, versus trading activity in the underlying portfolio. This results in greater tax efficiency because the portfolio is not impacted by the shareholder activity that occurs on the exchange.
E. Principal Uses of Actively Managed ETFs
State Street believes that actively managed ETFs will be beneficial to investors in a number of situations. Actively managed ETFs could potentially serve as short-term or long-term trading vehicles, allow investors to gain exposure to an asset category in a manner similar to index-based ETFs and play a significant role in an investor's hedging strategies. State Street believes that, like index-based ETFs, actively managed ETFs will appeal to both individual and institutional investors.
State Street also believes that the potential for a closed-end mutual fund to be converted into an actively managed ETF exists. However, the closed-end fund's shareholders and sponsor would have to agree that such a conversion would be beneficial to the fund and the shareholders. Additionally, the investment limitations applicable to an open-end fund, which would also apply to an actively managed ETF, may not be appropriate for a closed-end fund. While the potential exists for any fund to be an ETF, the success of the ETF will be dependent on the merits of the investment strategy
V. Exemptive Relief from the Investment Company Act for Actively Managed ETFs
A. Relief for ETFs to Redeem Shares in Large Aggregations Only
State Street believes that actively managed ETFs will not present any new issues with respect to the exemptions which allow for current ETFs to redeem their shares only in creation units. While State Street recognizes that the potential for more significant deviations between market price and NAV exists with actively managed ETFs, the fact that a fund's cash component may vary more significantly should not affect the relief granted from the definition of "redeemable security." Further, as mentioned above, State Street believes that the current disclosure requirements are sufficient to safeguard against investor confusion.
B. Relief for ETF Shares to Trade at Negotiated Prices
State Street believes that actively managed ETFs will not present any new issues with respect to the exemptions which allow ETF shares to trade at negotiated prices. State Street believes that with proper disclosure to all parties, actively managed ETFs do not create any new potential for discrimination or preferential treatment among investors purchasing and selling shares in the secondary market and those purchasing and redeeming creation units. State Street would suggest that, like existing ETFs, actively managed ETFs include disclosure which states that individual shares of actively managed funds will be sold at market price while creation unit aggregations of ETF shares will be processed at NAV.
C. Relief for In-Kind Transactions between an ETF and Certain Affiliates
State Street believes that actively managed ETFs will not present any new issues with respect to the exemptions which allow for in-kind transactions between an ETF and certain affiliates. We expect that all shareholders, regardless of affiliation, will be notified simultaneously of material events.
D. Relief for Certain ETFs to Redeem Shares in More than Seven Days
State Street believes that actively managed ETFs will not present any new issues with respect to the exemptions which allow certain shares to redeem in more than seven days. Actively managed ETFs with the flexibility to invest in certain foreign securities will still need to request this relief.
VI. Potential New Regulatory Issues
A. Potential Discrimination Among Shareholders
In response to the Commission's question regarding whether investors who create and redeem in Creation Units would be in a different position than retail investors who buy and sell ETF shares only at market price, we assert that actively managed ETFs would present no greater risk of such difference than existing ETFs.
B. Potential Conflicts of Interest for an ETF's Investment Adviser
In response to Commission concerns regarding conflicts of interest for an ETF's investment adviser, we believe that actively managed ETFs present no greater risks than open-end investment companies. We further assert that an investment adviser to an actively managed ETF would not be in a position to create supply or demand for securities if the Creation and Redemption Baskets are the same. And even if the Creation and Redemption Baskets were different, there is no guarantee that daily trading activity would occur.
State Street thanks the Commission for this opportunity to provide comments on the issue of actively managed ETFs. If you have any questions concerning these comments, please contact the undersigned at 617-664-4489.
/s/Agustin J. Fleites
Agustin J. Fleites
|1||State Street does not believe that limiting actively managed ETFs to certain investment objectives or policies designed to ensure sufficient liquidity is necessary.|
|2||See Guide 4 to Form N-1A.|