1585 Broadway
New York, New York 10036

May 3, 2002

Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: Concept Release Regarding Actively Managed Exchange-Traded Funds -- File No. S7-20-01

Dear Mr. Katz:

Morgan Stanley & Co. Incorporated1 strongly supports regulatory initiatives to expand the availability of regulated investment fund products, such as exchange-traded funds, or ETFs, to U.S. investors.

We believe that ETFs provide important advantages given the product's simplicity, transparency and liquidity. Like traditional mutual funds, ETFs allow investors the benefits of professional management, at a relatively low cost. ETFs became a possibility because of regulatory flexibility. We believe that there are a number of ways in which mutual funds and related products, such as ETFs, can be developed and expanded to provide customized, new investment alternatives to the U.S. market. We urge the Commission to work with the industry to support development of innovative ETF and mutual fund products.

One way in which the Commission can encourage innovation is by streamlining the exemptive application processes for mutual funds and ETFs. The Commission could set timetables to ensure that beneficial new products and new funds contained in existing mutual fund or ETF families may be brought to market expeditiously.

We support approval of new types of ETFs, including Bond ETFs (i.e., ETFs linked to an index of debt securities) and actively managed ETFs. Although these products would not replace mutual funds, especially in respect of long-term investors, the products would provide potential trading tools to short-term-focused institutional and retail investors who want to trade in and out of market exposures in a single trade.

Bond ETFs would provide a significant amount of liquidity and transparency to the bond market for the first time. The product would also allow investors to obtain exposure to broad sections of the yield curve through a single security, and in low enough denominations to facilitate investment by retail investors. We urge the Commission to approve the pending applications for Bond ETFs.

Although actively managed ETFs do present some structuring and regulatory challenges, in our view, the product could be structured in a manner that would facilitate liquidity and transparency sufficient to support active trading, tight pricing, and arbitrage. We also believe that the instruments could be structured in a manner to minimize the possibility of being "front run".

We urge the Commission to evaluate its existing rules as they apply to ETFs and mutual funds. There are a number of rules under the Investment Company Act of 1940, as amended (the "'40 Act"), the Securities Exchange Act of 1934, as amended (the "Exchange Act") and the Securities Act of 1933, as amended (the "Securities Act") that we believe should be modified. These rules were adopted prior to the growth of information technology and are outdated. We believe that changing the regulations will benefit investors by promoting more education about the products, eliminating artificial investment barriers that disadvantage regulated fund vehicles as compared to unregulated vehicles, and reducing legal risk and uncertainty associated with the instruments. In our view, the Commission has plenary exemptive authority to make the following changes:

1. Encouraging Innovation by Streamlining the Application Process

We urge the Commission to simplify the process by which mutual funds and ETFs receive exemptive, interpretive and no-action relief. We believe that fund regulation provides important safe-guards to investors, but we believe that retail investors are sometimes disadvantaged, as compared to institutional investors (which can invest in unregulated products such as hedge funds), by the Commission's conservatism in acting on exemptive applications. We believe that the Commission should establish a streamlined process for approving existing product lines and a more flexible review process for new products. The current 1-3 year review process for seasoned products, such as ETFs, is unnecessarily long. Delays in regulatory review can discourage innovation and push investment managers to focus on privately placed or offshore fund products rather than ones that are available to the general investing public in the U.S.

For index-based ETF applications, we recommend that the Commission limit the exemptive, listing and no-action process under the three Acts to 90 days. For applications relating to new types of ETFs, we believe that the review and approval process should be limited to 6 months. We support the idea raised by Paul F. Roye, Director of the Division of Investment Management, to establish a rule that would codify conditions imposed by exemptive orders and facilitate launching of ETFs that are similar to those previously passed on by the Staff. 2

2. Actively Managed ETFs

A. Benefits

Mutual funds provide substantial benefits to investors and, in particular, to individual investors, through diversification (and, accordingly, risk reduction), professional expertise and economies of scale not otherwise attainable for investors with limited assets. We believe that actively managed ETFs should provide investors with many of the existing benefits of mutual funds with the added benefit of intra-day liquidity and an ability to minimize capital gains and losses through the in-kind creation/redemption feature.

B. Concerns that Actively Managed ETFs will not trade at NAV

The Commission expressed concern that actively managed ETFs may experience greater deviations between market price and the NAV than index-based ETFs. The Concept Release suggested that this deviation could lead to disparate treatment for different classes of investors and accord preferential treatment to authorized participants (who are the only persons who may create and redeem units at NAV) as compared to retail and other investors purchasing and selling units in the secondary market (who will trade at the market price). Although no one can predict for certain how the product will trade, we do not believe that actively managed ETFs will trade at a material discount or premium to NAV, provided that: (1) substantially all of the stocks in the underlying portfolio are liquid, (2) a significant portion of the portfolio has been disclosed to the market, (3) the market has been given detailed parameters regarding the portion of the portfolio that has not been disclosed (i.e., sector, liquidity ranges, volatility, average price over a 30 day period, percent of outstanding held, percent of daily volume held, dividend yield, exchange on which listed and traded and foreign exchange risk) and (4) the ETF is created and redeemed on an in-kind basis using a basket of securities that conforms to the portfolio parameters provided daily.

We note that the Commission has, in the past, raised similar concerns about index-based ETFs. In general, we believe that these concerns have proven to be unfounded. When the first ETF, SPDRs, began trading in 1993, the future of the product was unknown and trading volume was relatively low. As time has gone on, the QQQ and the SPDR have become extremely popular and, based on our observations, are now some of the most actively traded stocks in the U.S. market. SPDRs have traded in line with NAV since inception, exhibiting little if any deviation. While institutions, rather than individuals, are the primary source of creation and redemption activity (given the large dollar value that creation units represent), in our experience the in-kind creation/redemption mechanism together with the ability to arbitrage the product has meant that ETF shares trade very close to their NAVs, which is a benefit to all investors.

ETFs that track foreign indices have, from time to time, traded at prices that differ from the funds' NAV. In our judgment, the reasons behind this deviation are complex and relate to factors such as after-hours trading and time differences between the two trading markets, as well as the fact that NAV is calculated only once a day.3 As a result of differences in the time zones between the U.S. (where the ETF trades) and the foreign country (where the underlying portfolio stocks trade), the NAV does not capture normal price discovery that takes place following the close of the local market. Differences in an ETF's NAV and its market price may come about as a result of this price discovery. Whereas closed end funds have traded at a discount to NAV due to imbalances in supply and demand, ETFs based on U.S. stocks have traded at levels that closely track NAV and ETFs based on non-U.S. stocks have traded in line with the prices of the underlying stock basket. We have no reason to believe that actively managed ETFs would not follow this pattern.

Even if the Commission were to determine that new forms of ETFs do pose a significant risk of trading at a discount or premium to NAV, we do not believe that the Commission should delay approval of the product for this reason. Instead, we would urge the Commission to address any perceived investor risks by requiring additional risk disclosure.

C. Structure and Operation of an Actively Managed ETF

We agree with the Commission that some changes in the operations currently employed by index-based ETFs will be necessary to accommodate an actively managed ETF. These objectives could be achieved in a number of ways, including requiring periodic but not daily disclosure of NAV and imposing restrictions on the composition of the portfolio.

Morgan Stanley favors an approach that would limit re-balancings of the ETF to a small portion of the fund over a given time period. For example, the Commission could require that 90% an actively managed ETF's portfolio remain static each week (the "Fixed Portion of the Portfolio") while the remaining portion of the portfolio would be available to be traded by fund manager (the "Active Portion of the Portfolio"). Creations and redemptions during the week would track the Fixed Portion of the Portfolio on an in-kind basis and provide for payment of the Active Portion of the Portfolio in cash. Upon agreement between the authorized participant and the ETF manager, redemptions and creations with respect to the Active Portion of the Portfolio could, in the alternative, be effected through a customized basket of stocks in order to achieve tax efficiencies. The primary listing exchange would provide indicative information regarding the NAV of the ETF (including the Active Portion of the Portfolio) throughout the trading day.4 In order to encourage arbitrage (which, in our experience, tends to ensure that an ETF trades at or about NAV), we would recommend that actively managed ETFs be limited in their ability to obtain leverage solely to publicly traded derivative instruments. We also believe that the Commission should restrict the investment objectives or policies of actively managed ETF to require that 100% of the investments of the fund, when purchased, qualify as "liquid securities".

We would expect the Commission to require managers of actively managed ETFs to disclose the Fixed Portion of the Portfolio weekly and to provide "blind" information regarding the balance of the fund's portfolio on a daily basis. The "blind" portfolio information would inform traders about the risk characteristics of the portfolio sufficiently to allow them to price the Active Portion of the Portfolio but in a manner that minimizes the risk of frontrunning. This "blind" information would include the following with respect to each stock in the Active Portion of the Portfolio: liquidity ranges, volatility, average price over a 30 day period, percentage of outstanding held, percentage of daily volume held, dividend yield and the name of the exchanges on which the stock is listed and traded. In addition, the "blind" information would describe the portfolio generally by including concentrations across markets and sectors, portfolio Beta5 and foreign exchange exposure. We believe that this level of information, which is similar to the information provided to broker dealers in connection with program trades bid out on a "blind basis", is sufficient to allow arbitrageurs and traders to trade the ETF. Actively managed ETFs, like traditional mutual funds, would also be required to disclose the composition of 100% of the entire portfolio semi-annually in arrears.

Creations and redemptions for actively managed ETFs could be effected on an in-kind basis in respect of the Fixed Portion of the Portfolio and on a cash basis in respect of the Active Portion of the Portfolio. Under this approach, investment advisers might be required to disclose the Fixed Portion of the Portfolio (e.g., 90% of the total portfolio) once a week.6 As a result, an investor would know at all times exactly what it would receive upon redemption. From the manager's perspective, however, the structure could be made flexible by allowing a manager to offer an authorized participant an option to create or redeem the Active Portion of the Portfolio on an in-kind basis in whatever customized manner the manager might elect. The ETF manager could agree with an authorized participant to accept upon redemption a basket of those securities that the fund wanted to trade out of rather than cash in respect of the Active Portion of the Portfolio. Customization could be done in a manner so that the authorized participant would not know the manager's strategy but would only be privy to one select part of the overall strategy. If effected in this manner, actively managed ETFs would be able to re-balance their holdings in a tax efficient manner and manage their cash positions effectively. We do not believe that creation and redemption through mutually agreed customized baskets would advantage authorized participants as compared to other market participants. In order to ensure that the ETF is not adversely affected by front-running as a result of providing customized baskets, the Commission could require the appropriate self-regulatory organization to examine trading activity by authorized participants and require authorized participants to have an appropriate compliance infrastructure to deter such activity.7

We believe that it is essential to attract arbitrage in order to ensure that the ETFs trade at or about NAV. Arbitrage tends to minimize any divergence between the trading price and NAV as well as to create liquidity in the product. We believe that actively managed ETFs structured in the manner described above will attract arbitrageurs.8

D. In-Kind Creation/Redemption

Actively managed ETFs should be encouraged to use in-kind creation and redemption procedures. In-kind creations and redemptions generally minimize capital gains and losses borne by ETF investors as well as trading and related expenses otherwise borne by the fund. In our experience, there are no "fails" in respect of creations and redemptions; settlement of U.S. equities is effected through the facilities of The Depository Trust Company and the National Securities Clearing Corporation and settlement of non-U.S. equities is generally coupled with a collateral posting requirement (unless the equities are delivered on trade date).

In establishing parameters for actively managed ETFs, however, the Commission should allow ETFs discretion to create and redeem all9 or a portion of the basket (including of the Fixed Portion of the Basket) on a cash, rather than in-kind basis. Cash creations give the fund flexibility to accept cash from authorized participants in stocks they are prohibited from trading in for statutory or other reasons.

E. Possible Uses for Actively Managed ETFs

We believe that actively managed ETFs will primarily be of interest to retail investors who are interested in frequently trading in and out of fund holdings. Actively managed ETFs would provide retail investors with all of the applications that have made index-based ETFs popular (i.e., access to transparent portfolios in real time, at or near NAV) with the added advantage of active management by some of the world's best money managers. Investors should benefit from the real time, market-based pricing offered by ETFs and the ability to obtain exposure to a diversified basket of securities through a single stock.

F. Section 22(d) and Rule 22c-1 - Trading at Negotiated Prices

The sale of shares of an actively managed ETF at market prices, rather than at NAV, should not implicate Section 22(d) of and Rule 22c-1 under the '40 Act.10 ETFs are designed to give both institutional and retail investors a cost-effective way to get in and out of a market on an intra-day basis, rather than waiting until the end of the day to price their investment. This source of liquidity is beneficial to investors and allows them to pro-actively manage their risk by electing when and how to trade in or out of an investment.

We do not believe that allowing trading of shares of an actively managed ETF in the secondary market would cause disruption of orderly markets. We note that the trading of index-based ETFs has not caused adverse consequences for the market. In our experience, ETFs have been an important tool in stabilizing volatile markets. On September 17, 2001, which was the first day after the September 11 tragedy on which equity trading markets opened for trading in the U.S., the ETFs opened for trading very soon after the opening bell while a number of single stocks did not open for at least an hour after the opening. ETFs provided institutional investors an immediate vehicle to equitize cash and to obtain short exposure, for hedging or other risk management reasons.

3. Recommended Regulatory Changes

The Commission needs to evaluate its rules to encourage more communication with investors about mutual funds and ETFs and to facilitate education of the marketplace about new products. We believe that it is more appropriate to rely upon the restraints of the anti-fraud rules to constrain inappropriate marketing behavior than on Securities Act principles which create concerns that materials may be deemed to be a non-conforming prospectus and, thereby give investors a rescission right. These changes would facilitate "plain English" communication with investors about the risks and rewards of innovative fund products.

A. Research on and marketing of ETFs

Rule 139 under the Securities Act. The distribution by broker-dealers acting as authorized participants, market makers, or otherwise participating in the distribution of index-linked mutual funds and ETFs of research materials relating to the funds may constitute an offer under Section 5 of the Securities Act. Because these funds are deemed to be continuously "in distribution," the distribution of such research reports, if not accompanied or preceded by a prospectus, would need to comply with an exemption from Section 5 of the Securities Act or otherwise not constitute an "offer" under the Securities Act. Given the business impracticality and expense of distributing prospectuses with or prior to distributing a research report and the inherent impossibility of a research report complying with the requirements of Rule 134 under the Securities Act,11 Morgan Stanley believes that it benefit both retail and institutional investors if Rule 139 under the Securities Act were amended to include within its safe-harbor research relating to index-linked mutual funds and ETFs.12 Independent research provides investors with information regarding how to evaluate index-linked mutual funds and ETFs and assists them in making an informed investment decisions.13

We believe that the underlying purposes of Rule 139 would be met by providing a safe-harbor for research regarding ETFs and index-linked mutual funds so long as the market capitalization and seasoning safeguards in place for operating companies were applied to funds.14 In order to be eligible for exemptive relief under Rule 139, a research report would be required to be produced and distributed in the ordinary course of business. In addition, research should be subject to information barriers designed to prevent the misuse of material non-public information and would be required to be reviewed by an appropriately licensed employee of the broker-dealer. In our view, applicable antifraud provisions (including required disclosure by the broker dealer about possible conflicts of interest) as well as the NASD advertising rules already provide sufficient protection against the possibility that a research report could be used to "hype" or "condition" the market for mutual funds or ETFs.15

Rule 482 under the Securities Act. The Commission should revise Rule 482, pursuant to authority granted in Section 24(g) of the '40 Act,16 to eliminate the requirement that the material qualifying under the Rule "contains only information the substance of which is included in the Section 10(a) prospectus." We believe that this qualification is unnecessary to protect investors given the applicability of the anti-fraud rules under the federal securities laws. Moreover, we believe that this requirement severely limits the ability of interested persons to rely on Rule 482 and, thus, prevents third party sources of information regarding funds, such as broker-dealers, from publishing marketing material or research to assist investors in learning about and understanding the product. We also believe that the Commission should clarify that a third party source other than the fund itself (for instance, a broker-dealer) can rely upon Rule 482 to create and publish advertisements relating to the ETF, as long as the entity complies with the content and disclosure requirements of the rule.

The current rules of the Commission provide that any performance information provided to investors must meet "standardized performance" criteria and must be based on NAV.17 We urge the Commission to eliminate this requirement for ETFs. We see no basis for treating performance information regarding a publicly-traded ETF, for which stock prices are available in the newspapers, any differently from performance information for any listed stock of an operating company, which is not subject to regulation or standardization.

Rule 15c3-1 under the Exchange Act. Under Appendix A of Rule 15c3-1, all capital charges for index baskets, options and futures are calculated using an approved risk based model. Currently, the only approved model for securities is the Risk Based Capital Model of the Options Clearing Corporation. Under this model, an index basket of securities hedged with a futures contract would require a capital charge of 5% for highly capitalized broad and narrow-based indices and 7.5% for non-highly capitalized broad-based indices. In addition, the capital charges for ETFs hedged with a basket of underlying securities is also 5% or 7.5%. We believe the appropriate levels of regulatory capital applied to index baskets hedged with an ETF and index futures hedged with an ETF should be equal to 1% of the market value of the basket (where the correlation between the ETF and the stock or the futures contract is high). We request that the Commission change the relevant provisions accordingly.

Section 12(d)(1) of the `40 Act and related restrictions on fund ownership contained in Section 3(c)(1) and Section 3(c)(7) of the '40 Act. The current ownership restrictions of Section 12(d)(1) of the '40 Act limit the ability of funds to invest in index-linked mutual funds and index-linked ETFs. The provisions impose restrictive limits and discourage investment below the thresholds due to the complexity of monitoring for compliance. We believe that the Commission should exempt index-based mutual funds and index-linked ETFs from the fund ownership restrictions. We recommend that the exemption apply only to funds and ETFs managed by advisers that are not affiliated with the investing fund in order to prevent conflicts of interest.

The limitations in Section 12(d)(1) were enacted in 1970 to address four potential abuses by companies that act as holding companies for registered investment companies: (i) the acquisition of voting control over the investment company; (ii) the exercise of undue influence over portfolio management through the threat of large scale redemptions and loss of advisory fees to the advisor, and the disruption of the orderly management of the investment company through the maintenance of large cash balances to meet potential redemptions; (iii) the complexity of the structure with the resultant difficulty in appraising the true value of an investor's security; and (iv) the layering of sales charges, advisory fees and administrative costs. We do not believe that allowing funds to invest in index-linked mutual funds and ETFs of unaffiliated advisers would raise any of these concerns.

Since the investment strategy of an index-based mutual fund or ETF is relatively "hard wired" (i.e., the fund must track a designated index), we do not think there would be any incentive to seek control of the mutual fund or ETF. In our experience, the primary reason that investors seek control of an entity, including closed end funds, is to change the business or investment strategy in order to enhance investor returns. Given that this would not be possible in the case of an index-based fund because its business purpose is to the track the identified index, we not believe that there would ever be a realistic risk that a fund investor would seek to take control of an index-based mutual fund or ETF.

With respect to the second concern, we believe that the "hardwired" nature of the investment strategy makes it uneconomical for a large investor to seek to influence management of the fund's portfolio. Likewise, there is no risk that an index-linked mutual fund or ETF would be required to maintain large cash balances as a result of allowing funds to invest in ETFs since ETFs generally create and redeem their shares on an in-kind basis only.

ETFs do not have complex structures, are generally unleveraged and follow restrictive investment guidelines (e.g., a number of index-based ETFs have no discretion to do anything other than fully replicate the index by acquiring each component stock). In addition, ETFs, unlike traditional mutual funds, are subject to constant price discovery in the public securities market and invest exclusively in liquid securities, which the fund discloses to the market on a daily basis. We believe that these factors would ensure that investors will always be able to appraise the true value of their ETF holdings.

Finally, ETFs offer a number of significant benefits to investors. ETF shares are not subject to sales charges and tend to have relatively low management and other expenses. They provide exposure to a broad market segment through a single security. Since ETFs are created and redeemed on an in-kind basis, they do not present the same liquidity and market impact risks that ordinary mutual funds (which must liquidate holdings into the market in order to meet redemption requests) do. In addition, ETFs tend to be more tax efficient than traditional mutual funds as a result of the in-kind creation and redemption mechanism. We do not believe that there is any policy or other reason to deprive fund investors of these benefits. We request that the Commission exempt index-based ETFs from the fund of funds rules.

Section 12(d)(3) of the '40 Act. The ownership restrictions on stocks affiliated with broker-dealers have been a particular constraint for index-based ETFs since a number of major indices (such as the Dow Jones Industrial Average) include those stocks. In the index context, the case is particularly compelling to grant blanket relief since the fund is not "taking a view" on a financial services company stock but simply tracking an index. The identity of the stocks that go in and out of indices is outside of the control of the fund and, thus, not subject to the types of abuses (i.e., interlocks between funds and broker-dealers) that the section was intended to prevent.

Clarification of Interpretations Relating to Electronic Communications. The Staff should confirm that educational and marketing information regarding ETFs contained on a broker-dealer or investment-manager sponsored website would qualify as "free writing" and would not be a non-conforming prospectus under Section 10(a) of the Securities Act, provided that the website includes a hyperlink to the applicable prospectus or reproduces the prospectus on the site. The Staff should eliminate any requirement that investors provide a consent to receipt of the prospectus electronically since the use of computers has become widespread and anyone who is electronically accessing information from a website has the opportunity to access prospectuses that are either posted on the website or available by clicking on a hyperlink.

Revise Rule 134 under the Securities Act. Rule 134 under the Securities Act should be amended to allow for dissemination of additional general information regarding an ETF by either the fund manager or a broker-dealer without requiring dissemination of a prospectus. The Rule should expressly contemplate reliance on the rule in the case of ETFs and should confirm that term-sheet type information (i.e., name of manager and other service providers, ticker symbol, trading hours, names of authorized participants, manager's fees, distributor's website for the ETF and marketing contacts at the broker dealer) is allowed within the scope of the Rule and would not give rise to an "offer" for which a Section 10(a) prospectus would be required.18

Thank you again for giving us this opportunity to comment on the Commission's Concept Release. If you have any questions, please feel free to contact the undersigned at (212) 761-7900.


R. Sheldon Johnson

Managing Director

cc: Paul F. Roye
Alan Beller
Annette Nazareth
Michael W. Mundt
Nadya B. Roytblat
(Securities and Exchange Commission)
Georgia Bullitt
Heather Seidel
(Morgan Stanley)

1 Morgan Stanley is registered with the SEC as a broker dealer, acts as an authorized participant for all U.S.-listed ETFs and carries out an active customer facilitation business in ETFs.
2 See Speech by SEC Staff: Regulatory Issues Involving Exchange Traded Funds, at the American Stock Exchange Symposium on Exchange Traded Funds, New York, New York, on January 14, 2002.
3 See D. Litt and Y. Jhirad, MSCI iShares and Their Relationship to Net Asset Value, Morgan Stanley Quantitative Strategies, August 2000. Based on an historical analysis of the correlation between the inter-day returns of the iShares MSCI Japan, the NAV of the iShares MSCI Japan and the underlying basket of stocks, Morgan Stanley analysts found that the highest correlations were found between the inter-day return of the iShares (i.e., from the open to the close in the U.S. market) on the one hand and the overnight gap associated with the underlying basket of stock (i.e., close to open in the Japanese market) on the other hand. The correlation between the ETF's official NAV and the overnight gap associated with the underlying basket of stock, on the other hand, were significantly lower. The authors conclude that NAV may not be an optimal measure of short-term value of the iShares.
4 Based on our discussions with the American Stock Exchange LLC (the "Amex"), we believe that the Amex does have the necessary pricing models and infrastructure to disseminate such an indicative NAV for an actively managed ETF.
5 We define Beta as the portfolio's sensitivity to a change in the broader market based on historical data. As an example, an X% return in the broader market would result in an expected return for the portfolio of (beta x X%), all things being equal.
6 We believe that allowing a manager to re-balance approximately 10% of a fund weekly would provide sufficient flexibility to substantially all fund managers to achieve their objectives. In our experience, mutual funds generally would not trade out of more than 10% of the fund on a weekly basis. According to Lipper (a wholly owned subsidiary of Reuters S.A.), the average annual turnover for U.S. large cap mutual funds was 94% in 2001.
7 Broker-dealers are already subject to prohibitions against front running in connection with their securities businesses. As a result, authorized participants should already have in place compliance procedures designed to prevent and monitor frontrunning.
8 We believe that the Commission can largely eliminate any incentive for managers to enhance arbitrage opportunities at the expense of performance by establishing uniform standards for daily "blind" disclosure of portfolio information and weekly disclosure of Fixed Portion of the Portfolio. We also believe that fund boards of directors and boards of trustees perform an important policing function with respect to potential conflicts of interest.
9 In light of regulatory restrictions, several ETFs on foreign stocks may be created and redeemed on a cash basis only. Although those ETFs are less tax efficient than those that are created and redeemed on an in-kind basis, we believe they still provide investors with a useful product. We note that the iShares MSCI Taiwan ETF, which creates and redeems for cash because of local law restrictions, is a popular ETF and currently has approximately $170 million in assets.
10 We note that the Commission has questioned the continued need for Section 22(d), given the changes in the marketplace and regulations since it was first adopted in 1940. The Commission has suggested that price competition in respect of mutual fund shares might benefit rather than harm investors. See generally Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment Management, Commission (May 1992), at Chapter 8, Section II.
11 Rule 134 under the Securities Act exempts from the definition of "prospectus" in Section 2(a)(10) of the Securities Act investment company advertisements that contain only certain basic items of information about the funds as permitted in the rule (for example, the fund's name and investment policies and objectives).
12 Rule 139 is a safe harbor from Section 5 of the Securities Act for the publication by a broker-dealer of information, an opinion or a recommendation on an operating company, subject to certain requirements being satisfied. In a rulemaking proposal in 1998 the SEC proposed amendments to Rule 139 to provide more flexibility to broker-dealers who prepare research reports, although those proposed changes did not specifically address research that covers open-end management companies or unit investment trusts, such as ETFs. Securities Act Release No. 7606A (November 13, 1998) ("1998 Release").

We direct the Commission's attention to a comment letter discussing the proposed changes to Rule 139 in the context of expanding Rule 139 to include research on open-end investment companies from Raymond T. Abbott, Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") to Jonathan G. Katz, Secretary, Commission, dated May 9, 2001. We believe that this type relief is even more appropriate in the context of ETFs that trade on stock exchanges like other listed stocks.

13 We note that the Commission has previously and consistently recognized the beneficial role research can play in educating investors. See generally the Commission's releases concerning Rules 137, 138 and 139 (for example, see Securities Act Release No. 33-5101 (November 19, 1970)).
14 We also believe a broker-dealer should be allowed to publish an "industry" research report (as contemplated by current Rule 139(b)) that covers and gives a broad overview of all ETFs, or all ETFs in an objective recognizable category (such as all ETFs investing in small-cap domestic stocks) without regard to whether each ETF meets the equivalent capitalization requirement to Form S-3, i.e., that the issuer must have at least $75 million in market capitalization. If, however, the broker-dealer were to recommend or highlight a particular ETF within an industry report, we suggest that the ETF would need to meet the $75 million in assets requirement.
15 For instance, it may not be practicable for a broker-dealer to comply with the Instruction 1 to Rule 139(a) that a report be published with reasonable regularity (meaning that the broker-dealer was publishing research on the company before it began participating in a distribution) because the broker-dealer may not be able to delay acting as an underwriter for a particular ETF until after it has been publishing research on that ETF long enough to satisfy the "reasonable regularity" requirement. Also, the requirement in Rule 139(b) for industry reports that the broker-dealer have published a recommendation or opinion at least as favorable in its last industry related report concerning the issuer prior to the commencement of the distribution could not be met by a report on an ETF, since they are continuously in distribution. We note that the proposed changes to Rule 139 in the 1998 Release would have eliminated these two requirements (although replacing the second one with a different requirement).
16 Section 24(g) of the '40 Act, which was added to the Act pursuant to the National Securities Markets Improvement Act of 1996, gives the Commission the authority to permit the use of a prospectus relating to an investment company for purposes of Section 5(b)(1) of the Securities Act that contains information the substance of which is not included in the statutory prospectus.
17 See Rule 482 under the Securities Act and Rule 34b-1 under the '40 Act.
18 Note that we believe Rule 134 should be expanded generally to facilitate marketing of structured equity products, such as equity linked notes, based on a generic term sheet which includes general information regarding the structure of the instrument, including indicative pricing, but is clearly marked as subject to Rule 134 and not an offer or sale of a security.