Friday, November 14, 2014

Eaton Vance Scores Huge Victory on Non-Transparent ETFs

The Gateway Opens for Exchange Traded Managed Funds

On November 6, 2014, the Securities and Exchange Commission granted Eaton Vance’s request to launch an "exchange traded managed fund" (ETMF), a new kind of exchange traded fund.  Only a week before, the SEC provisionally denied similar requests for ETMFs from Blackrock and Precidian Investments


The ETMF concept was patented in 2005 by Gary Gastineau, one of the founders of the ETF industry, to solve what he thought was a major problem for ETFs: daily disclosure.  His patent was subsequently purchased by Eaton Vance.  ETMFs differ from traditional ETFs in that they are actively managed and use net asset value-based trading for market transactions.  The goal of ETMFs is to combine security selection by a fund manager with the intra-day trading and cost reduction characteristics of traditional ETFs. In an ETMF, a portfolio manager manages the fund’s portfolio like a traditional mutual fund. However, rather than publishing the contents of the fund’s portfolio daily as traditional ETFs do, allowing authorized participants to make creation/redemption baskets, the manager publishes a proxy portfolio that the manager is willing to use for creations and redemptions. The proxy portfolio does not give away information about what the manager is actually trading, but it approximates it. 

The Blackrock and Precidian requests each proposed to create actively-managed ETFs that, in lieu of disclosing their portfolio holdings on a daily basis, would publish an an approximation of the ETF’s NAV, called an “intraday indicative value” (IIV). The IIV, published every 15 seconds, would be a way to minimize discounts and premiums from the fund’s actual NAV.  


For this reason, the SEC dubbed ETMFs “non-transparent ETFs,” objecting to the lack of portfolio transparency inherent in the Blackrock and Precidian proposals.  Eaton Vance, however, appears to have addressed the SEC’s concerns. Eaton asserted in their application that in light of NAV-based trading, portfolio transparency is not necessary for ETMFs.  While acknowledging that daily portfolio disclosure is necessary for effective arbitrage and efficient secondary market trading of ETFs, in NAV-based trading market makers do not engage in arbitrage and assume no intraday market risk in their share inventory positions. That is because all trading prices are linked to NAV. There is no intraday market risk associated with ETMFs, Eaton explains, so there is no intraday hedging activity, and no associated requirement for daily disclosure of portfolio holdings.  Eaton further asserts that because share transaction prices would be based on end-of-day NAV, ETMFs can be expected to trade at consistently narrow premiums/discounts to NAV and tight bid-ask spreads even in the absence of daily disclosure of portfolio holdings.  


Eaton Vance’s explanation of why daily transparency is not necessary for ETMFs appears to have been persuasive, and their application won the day. In addition, on the day following the Eaton Vance order, the SEC approved the listing of Eaton's ETMFs on the NASDAQ Exchange.  Given the SEC’s apparent change of heart on Eaton Vance’s ETMFs, it is almost certain that Blackrock and Precidian will take advantage of the opportunity to request a hearing on their applications. Each firm has until November 17, 2014 to do so.  T.Rowe Price and Fidelity Investments are also expected to attempt to launch lines of ETMFs.  


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