Tuesday, November 19, 2019

Commissioners Jackson and Lee explain support for non-transparent ETFs

By Amy Leisinger, J.D.

The SEC has acted on four applications relating to a new type of exchange-traded fund providing less transparency. Unlike more standard ETFs, these funds will not provide full daily transparency of the exact securities in their portfolios and will instead provide "proxy" portfolios reflecting holdings. While ultimately supporting the actions, Commissioners Robert Jackson and Allison Herren Lee wrote separately to express concern that in times of stress, ordinary investors in non-transparent ETFs may not be able to get a fair price for their shares. While the SEC staff has provided conditions for these four applications designed to protect investors, future applications that do not address the potentially serious liquidity problems associated with the structure of nontransparent ETFs should give the Commission pause, they said.

Non-transparent ETFs. Precidian, Blue Tractor, Fidelity Beach Street, Natixis, and T. Rowe Price plan to introduce and operate actively managed ETFs that would not be required to disclose their portfolio holdings on a daily basis. Like other ETFs, the funds would issue shares redeemable in large aggregations only, and secondary market transactions would occur at negotiated market prices rather than at net asset value. Certain affiliated persons also would be permitted to deposit securities into, and receive securities from, the funds in connection with the purchase and redemption of creation units.

However, the applicants maintained that operating the funds as fully transparent would cause them to be susceptible to "front running" by others, which could harm the funds and their shareholders. According to the firms, non-transparent ETFs would allow investors to access to strategies more akin to those available through mutual funds while simultaneously taking advantage of the traditional benefits of ETFs, including lower costs and taxes and intraday liquidity.

On a daily basis, each fund would publish a basket of securities and cash designed to closely track its daily performance while not specifically detailing the fund’s portfolio. The "proxy" portfolio would serve as a tool for market participants to identify arbitrage opportunities and estimate the value of the fund’s holdings. The proxy portfolio also would allow market participants to gain exposure to the performance of the fund’s holdings so that it could serve to hedge a position in the fund’s shares.

Commissioners’ statement. Commissioners Jackson and Lee noted that the Commission has historically required ETFs to ensure that the market price for their shares does not substantially deviate from the value of underlying holdings and that authorized participants ensure that balance by consistently examining the value of the ETFs’ assets. With these new ETFs, the authorized participants will have access to "proxy" portfolios that provide enough information to keep the share prices in line with asset values, and the funds will establish thresholds for tracking error and bid-ask spreads, they said.

"These protections, combined with the Commission’s previous approval of one other non-transparent ETF—creating the need for competition that can help protect investors—convinced us that we could support these actions," the commissioners explained.

However, the commissioners noted, without those protections, in the event of limited liquidity, non-transparent ETFs come with the risk that ordinary investors will face wider spreads and find prices that do not accurately reflect share value. Jackson and Lee stated that they would be skeptical of non-transparent funds focused on different asset types without these protections in place and suggested that the Commission keep "close watch" over whether additional disclosure regarding the risks of non-transparent ETFs would be appropriate.

"[W]e look forward to hearing from the market about the limits of the nontransparent ETF model—and how we can make sure disclosures give investors the information they need about these funds," the commissioners concluded.