The new product will have characteristics of both mutual funds and exchange-traded funds.

On November 6, the U.S. Securities and Exchange Commission (SEC) issued a notice indicating that it intends to grant exemptive relief that would permit the launch and operation of a new type of pooled investment vehicle known as an “exchange-traded managed fund” (ETMF).^[1] The following day, the SEC also indicated that it will grant a proposed rule change filed by the NASDAQ Stock Market (NASDAQ) that will permit the exchange to list and trade ETMF shares.^[2]

The ETMF will be the first of its kind, with features of both exchange-traded funds (ETFs) and mutual funds. As described in the ETMF Notice and the Listing Notice, this hybrid structure is intended to provide many of the benefits of the traditional ETF structure, but it does not feature the daily transparency currently required for actively managed ETFs. For example, ETMFs are intended to appeal to retail investors who prefer the accessibility and cost structure of exchange-traded products.^[3] In addition, because the ETMF structure does not require daily disclosure of portfolio holdings, ETMFs are intended to address the concerns about front running and reverse engineering of portfolio holdings that have kept many active managers from launching actively managed ETFs.

What are ETMFs?

As with ETFs, shares of ETMFs may be created and redeemed only in transactions between broker-dealers (known as “authorized participants”) and the ETMF in creation-unit size. Creations and redemptions will typically be effected in kind to maximize tax efficiency and minimize transaction costs.^[4] ETMF shares, like ETF shares, will be listed and traded on national securities exchanges (e.g., NASDAQ). However, unlike ETF shares, ETMF shares will trade at prices based on the end-of-day net asset value (NAV) of the ETMF plus or minus a negotiated premium or discount. Like mutual funds, ETMFs are required to disclose their portfolio holdings only on a quarterly basis, with a 60-day lag.^[5]

The key features of ETMFs, compared to mutual funds and ETFs, are set out below.

Pricing of ETMFs

As with both ETFs and mutual funds, a daily NAV will be determined for each ETMF at the end of each trading day. As with ETFs, creation and redemption transactions will be based on the daily NAV of the ETMF. However, unlike ETF shares, which trade in the secondary market intraday at prices expressed as absolute dollar amounts (e.g., $10.25), ETMF shares will trade in the secondary market intraday at prices expressed as premium or discount to the ETMF’s to-be-determined NAV (e.g., NAV + $0.01 or NAV - $0.05). For each trade, the premium/discount (which may be zero) will be locked in at trade execution, but the final transaction price will not be determined until the end of the business day after the ETMF’s NAV is calculated. Similar to intraday orders to buy or sell shares of mutual funds, an ETMF investor will not know the price at which his or her order will be executed until after the NAV is calculated, though the investor will know the level of premium/discount to the NAV when buying or selling ETMF shares.

The ETMF Notice states that the amount of an ETMF’s premium or discount will depend on a variety of factors, including the supply and demand for the ETMF’s shares, transaction costs incurred by the ETMF as a result of creation and redemption orders (which would be passed along to authorized participants as transaction fees), competition among the ETMF’s market makers, inventory positions and strategies of the ETMF’s market makers, and the volume of trading in the ETMF’s shares.^[6] According to the ETMF Notice, the SEC approved the NAV-based trading approach in part because the approach creates market prices that will be directly linked to the NAV, and, as such, ETMFs can be expected to trade at consistently narrow premiums/discounts to the NAV and tight bid/ask spreads, even in the absence of full portfolio transparency.

“Composition Files” and Confidentiality of the ETMF’s Portfolio

Unlike actively managed ETFs, an ETMF’s daily portfolio holdings are not required to be publicly disclosed to the market. Each day prior to the start of trading, an ETMF will transmit a “composition file” to the National Securities Clearing Corporation (NSCC), which NSCC will then disseminate to the market. The composition file will reflect the basket of securities and cash that the ETMF will accept from authorized participants in connection with a creation order or will deliver to authorized participants in connection with a redemption order for that day. The same composition file will be used for both creation orders and redemption orders. The composition file will include both cash and securities to be delivered in kind.^[7] Each security in the composition file will be a current holding of the ETMF, but not all of the ETMF’s portfolio holdings will be in the composition file, and the weightings of the ETMF’s portfolio will not be disclosed. The composition file may also consist entirely of cash.^[8] Unlike ETFs, creation baskets based on an ETMF’s composition file generally will not reflect a pro rata slice of the ETMF’s portfolio. For example, to preserve the confidentiality of its investment strategy, the ETMF may exclude from the composition file securities that it plans to add or remove from its portfolio. Other than in limited circumstances in which cash-in-lieu will be permitted,^[9] all authorized participants will transact in the same composition file on a given day.  

The ability of ETMFs to routinely use creation and redemption baskets that do not represent a pro rata slice of the ETMF’s portfolio holdings is an important distinction between the treatment of ETMFs and the express requirements of ETF exemptive orders issued over the last several years.^[10] Another important distinction is the emphasis in the ETMF Notice placed on board approval of creation and redemption policies and procedures and oversight of the process by chief compliance officers. This treatment is consistent with the position that the ETF industry has been advocating in recent years with respect to ETF creations and redemptions and could signal a potential shift in the way the SEC intends to treat the ETF creation and redemption process in the future.

Trading of ETMFs

To accommodate this new pricing structure, NASDAQ will implement a new “NAV-based trading” protocol where all bids, offers, and execution prices for an ETMF will be expressed as a premium or a discount to the ETMF’s next-determined NAV. Trades in ETMF shares using the NAV-based trading protocol will be binding once orders are matched on NASDAQ, and transaction prices will be contingent on the ETMF’s NAV determination at the end of the trading day.^[11] After the ETMF’s NAV is calculated at the end of the day, it will be reported to NASDAQ, and all trades entered during the day with respect to that ETMF will be priced. Once each trade is priced, NASDAQ will deliver the data to NSCC for clearance and settlement, pursuant to the standard NSCC processes for exchange-traded securities. Trading prices will then be confirmed to the member firms participating in the trades.

Intraday Indicative Value

Unlike ETFs, which contract with their listing exchanges to disseminative intraday indicative values (IIVs)^[12] every 15 seconds, NASDAQ will disseminate an ETMF’s IIV only every 15 minutes. According to the ETMF Notice and the Listing Notice, a more frequent IIV is not necessary for ETMFs because market makers will not be subject to intraday risk, and, therefore, they will not need the calculation to assist them with continuously monitoring and hedging their risk. Instead, the 15-minute IIV is meant only to help investors determine if they want to transact in an approximate dollar amount of ETMF shares. The SEC even indicated in the Listing Notice that more frequent disclosure of the IIV could provide information about the ETMF’s current portfolio trading activity sufficient to permit traders to reverse engineer the ETMF’s trading strategy. Given that IIVs published every 15 seconds are often criticized as being “stale,” the usefulness of publishing IIV every 15 minutes remains to be seen. This differing treatment of IIVs is another important distinction between ETFs and ETMFs that investors will need to understand.

Differences Between ETMFs and Other Non-Transparent ETF Proposals

Shortly before the SEC indicated its intention to grant the ETMFs’ application for an exemptive order and NASDAQ’s proposed rule to list ETMFs, the SEC preliminarily denied two exemptive applications for actively managed non-transparent ETFs (Other Applicants)^.[13] The ETFs proposed by the Other Applicants differ from ETMFs in several ways.

First, the Other Applicants sought to operate non-transparent ETFs based on the traditional ETF intraday trading and pricing approach as opposed to the NAV-based trading used by ETMFs. As such, the ETFs sponsored by the Other Applicants would trade in the secondary market in absolute dollar terms (e.g., $10.25). The Other Applicants proposed various substitutes for daily transparency (discussed below), which the SEC indicated did not provide “an adequate substitute for portfolio transparency such that the proposed ETFs would consistently trade at or close to NAV.”^[14] According to the ETMF Notice, ETMFs, in effect, sidestepped this issue by linking the intraday trading price of the ETMF directly to the NAV (plus or minus a market-based premium or discount) and eliminating the need for market makers to engage in intraday hedging of their positions^.[15]

Another difference is that the ETFs proposed by the Other Applicants would have used a blind trust structure. Intraday trading would have occurred in a manner similar to the premium/discount trading that currently takes place in ETFs, though likely at wider bid/ask spreads as a result of the relative non-transparency. As proposed, authorized participants would have been required to establish a blind trust and appoint the ETF’s custodian as trustee. Creation orders would have been effected in cash. For redemption orders, the ETF (acting through its custodian) would have delivered in-kind portfolio securities to the authorized participant’s blind trust (thus, preserving the traditional tax benefits of in-kind redemptions for the ETF). The trustee would liquidate these holdings and pass along the cash proceeds to the authorized participant without disclosing the identity of the portfolio securities.

The Other Applicants’ proposals also heavily relied on the publication of the ETFs’ IIV every 15 seconds during the trading day, as well as the ETFs’ quarterly disclosure of portfolio holdings and prospectus disclosure of its investment strategy, suggesting that this information would be sufficient for authorized participants to hedge their risk.^[16] In addition, the proposed ETFs would have included a back-up mechanism for retail investors to redeem shares directly through the ETF other than in creation-unit size in certain circumstances. However, a redemption fee and brokerage commissions would have been incurred as a result of the transaction.

In denying the proposals of the Other Applicants, the SEC explained that daily portfolio transparency results in a “close tie” between an ETF’s market price and its NAV per share, which serves as the baseline for the ability of retail investors to transact at the same price as institutional investors, such as authorized participants.^[17] The SEC stated that the proposed structures of the Other Applicants “fall far short of providing a suitable alternative” to daily portfolio transparency.^[18] The SEC noted that ETF prospectus disclosure does not provide sufficient detail into an ETF’s portfolio and that quarterly disclosures of full portfolio holdings would be largely irrelevant because of the 60-day time lag. The SEC was also highly critical of IIV, stating that it is not subject to a uniform methodology of calculation and is calculated based on “stale data” compared to the “fractions of a second” at which market makers operate in the current market.^[19] Further, the SEC warned that IIV could be an insufficient indication of actual value for an ETF with fair-valued securities, thinly traded securities, derivative instruments, or foreign securities with significant time differences in market trading hours from the ETF’s shares. The SEC also warned that all of these factors could be exacerbated during times of market stress or volatility.

The difference between traditional ETF trading based on the correlation between the trading price of the ETF shares and the intraday value of the underlying ETF portfolio (which we shorthand as “IIV trading”) and NAV-based trading for ETMFs is that the former introduces intraday market risk, whereas NAV-based trading prices are based on the end-of-day NAV. The ETMF manager, in its application, asserted that, because ETMF market makers would not be subject to intraday market risk, they would not need to engage in intraday hedging activity, and, therefore, disclosing current portfolio holdings was not necessary to maintain a tight relationship between share trading prices and  NAV.^[20] This appears to have been the key factor in the SEC’s decision to approve the order for the ETMFs, while indicating a preliminary intention to deny the orders for the Other Applicants.

In addition to the Other Applicants, there are two pending applications for exemptive relief for ETFs that would use a structure that delivers a robust set of data to the market as a proxy for a daily transparent portfolio. These proposals would also seek to maintain portfolio confidentiality and also rely on the secondary market for an arbitrage pricing mechanism to keep the funds’ market prices of fund shares in line with the NAV.^[21] These proposals assume that portfolio transparency is only required by the SEC because it facilitates the pricing arbitrage mechanism that keeps market prices in line with the NAV, but that portfolio transparency is not a per se requirement for an ETF’s arbitrage pricing mechanism to function efficiently. Interestingly, these two proposals fit somewhat between ETMFs and the Other Applicants in that potentially more information would be disseminated to the market than provided in the Other Applicants’ applications, which could keep ETF market prices more in line with the NAV, but these other proposals would not go as far as the NAV-based trading of ETMFs.

Other Noteworthy Aspects of ETMFs

In addition to the items discussed above, the ETMF Notice and the Listing Notice set forth various conditions and regulators’ expectations with respect to these new products.

• Advertising. ETMFs will be prohibited from holding themselves out as open-end investment companies, mutual funds, or ETFs. In addition, as with ETFs, advertising materials with respect to ETMFs must indicate that they are not individually redeemable.  

• Publication of ETMF information. An ETMF’s adviser will be required to set up a public website, accessible for free, with current information about the ETMF that must include links to the ETMF’s prospectus and current documents. The website must also include the ETMF’s prior day’s NAV; intraday high, low, average, and closing trade prices (as NAV +/-); the midpoint of the highest bid and lowest offer prices as of the close; and the spread between the highest bid and lowest offer prices as of the close.

• NASDAQ oversight. NASDAQ will implement written surveillance procedures for ETMF shares. As the entity that will provide the ETMF’s daily composition file, NASDAQ will also implement and maintain procedures designed to prevent the use and dissemination of material, non-public information regarding the ETMF’s portfolio positions and changes in those positions.

• Broker-dealer disclosure requirements. NASDAQ will inform members by means of an information circular prior to each ETMF’s commencement of trading whether NASDAQ Rule 5745(f) applies to the ETMF, which would require members to provide purchasers with a written description of the ETMF no later than the time a confirmation is delivered. NASDAQ members would also have to include a written description with any sales materials provided to customers or the public and must include a statement in such sales material indicating the availability of the written description circular^.[22]

• Firewalls. If an ETMF adviser has an affiliated broker-dealer, it must erect a firewall between personnel to control access to information on the composition file and changes to the ETMF’s portfolio holdings. In addition, personnel who determine the ETMF’s portfolio must be subject to policies and procedures designed to prevent the use and dissemination of such non-material, non-public information.

Potential Market Impact of ETMFs

Retail investors seeking an exchange-traded product that provides exposure to active trading strategies at relatively low cost and with a trading price directly linked to the NAV may find ETMFs to be an appealing alternative to ETFs and mutual funds. However, although NAV-based trading may be appealing to some, others may find it less useful as it does not allow true intraday trading because all prices are tied to the end-of-day NAV. This limits the usefulness of the product in periods of sharp intraday declines. The new category may also be attractive to active managers who have until now opted not to sponsor exchange-traded products because of concerns about transparency. Institutional market participants (particularly, broker-dealers) should pay close attention to the market’s adoption of ETMFs because the product will likely require broker-dealers who act as authorized participants to become acquainted with new inventory management techniques, modified order placement and delivery protocols, and different legal contracts. In light of the differences between ETMFs and ETFs, broker-dealers who act as authorized participants may need to consider their ability to generate revenue from acting as an authorized participant to ETMFs. The viability of ETMFs will also depend on whether the SEC permits variations on this structure or otherwise opens the door to further non-transparent ETF structures. Because investors will have to learn a new way to trade, the success of educational efforts launched by ETMF managers and NASDAQ will also be paramount to the success of ETMFs as a new product.

_{[1]. See Eaton Vance Management, Eaton Vance ETMF Trust and Eaton Vance ETMF Trust II, Notice of Application, Investment Company Act Rel. No. 31,333 (Nov. 6, 2014), available here [hereinafter ETMF Notice]. The ETMF Notice indicates that interested persons may request a hearing by December 1, 2014, but, absent such a request, the SEC intends to grant the application.}

_{[2]. See NASDAQ Stock Market LLC, Notice of Filing of Amendment No. 1 and Order Granting Accelerated Approval of a Proposed Rule Change, as Modified by Amendment No. 1 Thereto, Relating to Listing and Trading of Exchange-Traded Managed Fund Shares, Exchange Act Rel. No. 73,562 (Nov. 7, 2014), available here [hereinafter Listing Notice]. The order grants accelerated approval of NASDAQ Rule 5745 governing the listing and trading of ETMF shares and amends various related NASDAQ rules. NASDAQ Rule 5745(b)(1) provides that NASDAQ will file separate proposals under section 19(b) of the Securities Exchange Act of 1934 before listing any specific ETMF shares. Any comments on the Listing Notice must be submitted to the SEC within 21 days after the Listing Notice is published in the Federal Register. NASDAQ’s original rule proposal, which was filed on February 14, 2014, is available here.}

_{[3]. With exchange-traded shares, ETMFs, like ETFs, would have reduced transfer agency fees compared to mutual funds. In addition, the ETMFs will not charge sales loads or pay any asset-based distribution or service fees.}

_{[4]. Typically, ETFs are created and redeemed in blocks of 25,000–50,000 shares. The size of ETMF creation and redemption units is expected to be somewhat smaller and range from 5,000 to 50,000 shares.}

_{[5]. Mutual funds are required to disclose their holdings in full at least once per quarter, with a lag of no more than 60 days, on Form N-CSR (annual and semiannual shareholder reports that include a schedule of portfolio holdings) and Form N-Q (quarterly reports of portfolio holdings for the first and third fiscal quarters where neither an annual nor a semiannual report is filed).}

_{[6]. The ETMF Notice makes clear that premiums and discounts would not be “sales charges” subject to NASDAQ Rule 2830. See ETMF Notice,supra note 1, at 5, n.10.}

_{[7]. The composition file will be constructed in accordance with policies and procedures that have been approved by the ETMF’s board of trustees and which will be administered by the ETMF’s chief compliance officer in accordance with Rule 38a-1 under the Investment Company Act of 1940.}

_{[8]. In this instance, the tax efficiencies and minimizing of transaction costs would be reduced compared to a composition file that was primary effected in kind.}

_{[9]. The ETMF Notice states: “An ETMF’s Basket could vary if the required policies and procedures of the ETMF allowed such differences by permitting an Authorized Participant to deposit cash in lieu of some or all of the Basket Instruments solely because: (a) such Basket Instruments, in the case of a purchase of a Creation Unit, are not available in sufficient quantity; (b) such Basket Instruments are not eligible for trading by the Authorized Participant or the investor on whose behalf the Authorized Participant is acting; or (c) a holder of Shares of an ETMF investing in foreign instruments would be subject to unfavorable income tax treatment if the holder received redemption proceeds in kind. A ‘custom order’ is any purchase or redemption of Shares made in whole or in part on a cash basis in reliance on clause (a) or (b). An ETMF may also determine, upon receiving a purchase or redemption order from an Authorized Participant, to require the purchase or redemption, as applicable, to be made entirely in cash.” ETMF Notice, supra note 1, at 8, n.16.}

_{[10]. Older ETF exemptive orders have more flexible requirements with respect to ETF creations and redemptions.}

_{[11]. NASDAQ has indicated that ETMF ticker symbols will have a unique identifier to indicate that they use the NAV-Based Trading system. NASDAQ has also stated that existing order types and interfaces will be used to transmit bids and offers on ETMFs to NASDAQ. NASDAQ’s proprietary data feed will use the “NAV +/-” format, but the consolidated tape will use a proxy price to stand in for the ETMF’s next-determined NAV. For example, a trade at a NAV + $0.02 would appear as $100.02 on the consolidated tape if $100/share was used as a proxy price for the to-be-determined NAV. NASDAQ has stated that it will work with member firms and market data providers to ensure that bid, offer, and execution prices that are disseminated to the investing public reflect the “NAV +/-” format. NASDAQ has represented that it will work with brokers to ensure that appropriate systems are installed prior to the launch of the ETMFs, which will permit buy and sell orders to be in “NAV +/-” format.}

_{[12]. IIV is based on the value of an ETF’s portfolio and is calculated by a calculation agent using the last available market quotation or sale price of the ETF’s portfolio holdings. The IIV is not the NAV; it is a reference value produced by a third party seeking to approximate the intraday value of an ETF’s portfolio holdings.}

_{[13]. See Precidian ETFs Trust, et al., Notice of Application, Investment Company Act Rel. No. 31,300 (Oct. 21, 2014), available here; Spruce ETF Trust, et al., Notice of Application, Investment Company Act Rel. No. 31,301 (Oct. 21, 2014), available here [hereinafter Spruce ETF Trust Notice].}

_{[14]. Spruce ETF Trust Notice, supra note 13, at 24.}

_{[15]. See ETMF Notice, supra note 1, at 10.}

_{[16]. The IIV would have been calculated by a calculation agent who would have had full insight into the ETF’s portfolio.}

_{[17]. See Precidian ETFs, supra note 13, at 8.}

_{[18]. Id. at 12.}

_{[19]. Id. at 15. The SEC noted that market makers do not rely on IIV currently and, instead, calculate their own NAV per share with proprietary algorithms that are based on daily portfolio transparency and that generally use IIV, “if at all, as a secondary or tertiary check . . . . ” Id. at 14. The SEC was not comforted by the Other Applicants’ suggestion that authorized participants would be able to create correlations with provided information over time and evaluate how various market factors effect IIV. See id. at 13.}

_{[20]. See Eaton Vance Management, et al., Application for Exemptive Relief, File No. 812-14139 (as most recently amended on Sep. 25, 2014), available here.}

_{[21]. Fidelity Beach Street Trust and related Fidelity entities filed an application with the SEC on September 26, 2014 (File No. 812-14364); T. Rowe Price Equity Series, Inc. and T. Rowe Price Associates, Inc. filed an application on September 23, 2013, which was later amended on March 14, 2014 (File No. 812-14214-01).}

_{[22]. The SEC indicated that members carrying an omnibus account for a non-member broker-dealer must inform such non-member that execution of an ETMF order will constitute an agreement by the non-member to make the written description available to its customers.}