Alert March 04, 2008

SEC Issues Exemptive Orders to Permit Actively Managed ETFs

The SEC issued exemptive orders that will allow the offering of actively managed exchange traded funds (“ETFs”).  The actively managed ETFs that received exemptive relief include funds that will invest in non-U.S. money market instruments, funds that invest in U.S. equity securities using quantitative screening techniques and a short-term U.S. debt fund.  ETFs are investment companies that are typically registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as open-end funds.  Unlike typical open-end funds, ETFs do not sell or redeem their individual shares at net asset value (“NAV”).  Instead, they sell and redeem shares at NAV only in large blocks (such as 50,000 shares) typically referred to as “Creation Units.”  National securities exchanges list ETF shares for trading, which creates a secondary market where ETF shares can trade at negotiated prices in non‑Creation Unit quantities throughout the day.  Because their operations do not conform to the limitations for any of the types of registered collective investment vehicles permitted under the federal securities laws, ETFs must obtain exemptive relief from certain provisions of the 1940 Act before they can conduct a public offering. 

The SEC has historically granted the necessary exemptive relief only to index based ETFs, which seek to track the performance of a specified domestic or foreign market index.  Because securities selection for an actively managed ETF is based on the ETF’s investment objectives and policies rather than the composition of an index, the SEC had expressed concerns that the arbitrage mechanism relied on to control discrepancies between an ETF’s market price and its NAV would be less effective for actively managed ETFs.  The conditions of the exemptive relief granted to actively managed ETFs generally track those for index based ETFs including the requirement that (a) before trading each day, the actively managed ETF’s adviser or sponsor publicly disclose the ETF’s portfolio, which will be the basis for its NAV at day’s end, and (b) the listing exchange make available an estimate of the ETF’s NAV at 15 second intervals throughout the day.  Two of the orders also provide for relief from (1) the 1940 Act limits on the ability of other registered funds to acquire shares of the actively managed ETFs and (2) the 1940 Act’s affiliated transaction limitations that would prohibit certain affiliates of an actively managed ETF from engaging in in-kind Creation Unit transactions with the actively managed ETF.