The SEC indicated last week that it plans to deny the applications of Precidian Investments and Blackrock for exemptive relief that would allow the firms to avoid daily disclosures of the portfolios of proposed actively managed ETFs. The firms argued that requiring the actively managed ETFs to disclose holdings daily would subject the funds to front running and free riding. Instead, the firms had requested to disclose holdings quarterly, the requirement for traditional mutual funds. In separately released notices, the SEC raised issues with the lack of transparency in the proposals.
The releases noted that, with previous applications for exemptive relief for actively managed ETFs, the SEC had required “a mechanism that would keep the market prices of ETF shares at or close to the NAV per share of the ETF” because, unlike open-end mutual funds, ETFs do not sell or redeem individual shares at NAV. The releases stated that “[t]o date, this mechanism has been dependent on daily portfolio transparency.” The agency argued that portfolio transparency allows market makers to calculate the intraday NAV per share, which in turn allows for arbitrage and maintains a market price that is closely tied to the NAV per share. The SEC expressed concern that the structure proposed by the applicants would not provide sufficient information for market makers to accurately perform such a calculation, potentially leading to the ETF trading at a material deviation from the NAV per share.
According to the SEC, the deviation between the market prices of the ETF and the NAV “would be contrary to the foundational principle underlying section 22(d) and rule 22c-1 under the  Act —that shareholders be treated equitably—and may, in turn, inflict substantial costs on investors, disrupt orderly trading and damage market confidence in secondary trading of ETFs.” The agency noted that the lack of transparency would also make it difficult for market makers in the ETF to hedge and manage risk, likely leading to wider spreads and exacerbating the difference between the NAV and price paid by investors. This issue would also likely be worse in times of stress and market volatility, when market makers may withdraw from the market due to uncertainty.
Rather than disclosing the ETF’s portfolio daily, the applicants claimed that transparency would be provided through the “intraday indicative value” (IIV), which would be calculated by a third party based upon the ETF’s daily portfolio holdings and disseminated by an exchange every 15 seconds during normal trading hours. However, the SEC stated that the IIV is an inadequate pricing signal because it is “not subject to meaningful standards,” and “[i]n today’s markets, 15 seconds is too long for purposes of efficient market making and could result in poor execution.”
To address concerns that the structure of the proposed ETF would fail to keep market prices close to NAV, the application included a back-up redemption option for retail investors. Under the proposal, where the ETF’s shares had traded at a discount of at least 5% from the NAV per share for 10 consecutive business days, retail shareholders would be able to redeem shares directly from the ETF for a period of 15 days, subject to a redemption fee of up to 2% and potentially brokerage fees. The SEC was concerned that due to the costs associated with the option, investors would be discouraged from exercising their redemption rights. More importantly, however, the SEC found that this back-up retail redemption option “does not cure the inherently flawed structure of the proposed ETFs here.”