Wednesday, October 19, 2011

Senate Hearings Examine Issues of Transparency and Leverage around Exchange-Traded Funds; SEC Staff Review Is Continuing

Senate hearings on exchange-traded funds examined issues of transparency, leverage and the use of derivatives in this growing area. Senator Jack Reed (D-RI), Chair of the Securities Subcommittee, said that it was time to ask some questions about exchange-traded funds, which are mutual funds that trade like stocks. Senator Reed noted that exchange-traded funds are a useful product that is growing rapidly, and at the same time causing concern over issues such as transparency and leverage, and the fact that sometimes the underlying instrument is not a stock but a derivative. He said that the hearing is not the end of congressional consideration of these issues.

Exchange-traded funds seek to provide investors exposure to a specific benchmark or investment strategy by investing in securities and other assets. Generally, ETFs must register as investment companies under the Investment Company Act. ETFs in the United States have grown to account for approximately $1 trillion in assets, or approximately 10 percent of the long-term U.S. open-end investment company industry, with U.S.-domiciled ETFs making up approximately two-thirds of global offerings.

In her prepared testimony, Eileen Rominger, Director of the SEC Division of Investment Management, said that SEC staff from across multiple Divisions and Offices are currently engaged in a general review of ETFs, which includes gathering and analyzing detailed information about specific products. For example, Commission staff is currently engaged in a general review of ETFs in connection with, among others, the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments in which they invest, fair valuations, efficiency in the arbitrage process and the relationship between market volatility and ETFs.

Responding to Senator Reed’s question on how transparent are ETF portfolios, Eileen Rominger said that generally the vast majority of ETFs have good transparency, which is a key benefit of an ETF portfolio. To address transparency concerns, noted the Director, actively managed ETFs are currently required to publish their holdings daily. Because there is no underlying index that can serve as a point of reference for investors and other market participants as to the fund’s holdings, disclosing the specific fund holdings ensures that market participants have sufficient information to engage in the arbitrage that works to keep the market price of ETF shares close to the net asset value f the fund or portfolio.

Senator Reed also expressed concern about highly leveraged ETFs that use derivatives. The SEC Director noted that feedback from market participants suggests that some investors may not fully understand the daily performance features of leveraged, inverse, and inverse leveraged ETFs, and the consequences of holding the shares of such ETFs over extended periods. To help address this issue, the Commission, together with FINRA, has issued guidance and other information to alert investors and other market participants of the risks of holding such ETF shares.

Separately, in March 2010 SEC staff determined to defer the consideration of exemptive requests for those products that fall under the Investment Company Act of 1940 Act that would permit the launch of new ETFs making significant investments in derivatives. Because leveraged and inverse leveraged ETFs often make significant use of derivatives, noted Ms. Rominger, deferring consideration of exemptive requests related to derivatives necessarily deferred the issuance of new orders permitting leveraged and inverse ETFs that would be subject to the 1940 Act

The SEC Director also observed that the types of ETFs introduced to the marketplace in the last few years have become increasingly complex. For example, some seek to track an index of futures on volatility of a portfolio of stocks, such as the S&P 500. Futures on volatility have added another dimension to the calculation to express future or expected volatility. In addition, the Commission has witnessed an increase in the past few years in the variety of actively managed ETFs introduced by sponsors.

For example, while an assortment of actively managed ETFs based on fixed-income portfolios is listed and trading in the marketplace, there have been an increasing number of actively managed ETFs that seek to primarily invest in instruments that raise concerns with respect to liquidity and transparency, including emerging market debt securities, high-yield debt securities, and other instruments. Commission staff is currently engaged in a review of these and other types of portfolios (such as those that hold illiquid, non-transparent or other types of investments) to determine whether the underlying instruments meet minimum liquidity and other thresholds, for purposes of transparency, fair valuation, and efficiency in the arbitrage process.

Regarding Senator Reed’s concern about derivatives in this area, the Director noted that the Commission staff is continuing to consider the ramifications of significant investments in derivatives for these products. She also noted the existence of an SEC Concept Release soliciting public comment on the use of derivatives by investment companies and on the current regulatory regime under the Investment Company Act as it applies to the use of derivatives by investment companies. The Commission will use the comments to help determine whether regulatory initiatives or guidance is needed that would continue to protect investors and fulfill the purposes underlying the 1940 Act.