Federal Register / Vol. 79, No. 207 / Monday, October 27, 2014 / Notices 63971 

62See Examining the Exchange-Traded Nature of 

Exchange-Traded Funds, Morningstar ETF Research 

(Feb. 11, 2013) (‘‘Morningstar ETF Report’’), at 21 

(‘‘To consider conducting an arbitrage transaction, 

arbitrageurs must be fairly confident that they will 

receive a return commensurate with the level of risk 

they are assuming. Therefore, it is likely that 

intraday changes to volatility (that is, risk) cause 

arbitrageurs to become more or less confident when 

transacting in the equity market for purposes of 

arbitrage and thus cause premiums or discounts to 

occur in the short term. . . . From the perspective 

of an arbitrageur, increased equity market volatility 

implies that the value of purchased equities relative 

to the value of the ETF’s shares is at greater risk 

to fall and thus increases the potential that arbitrage 

trade will be less profitable, if at all. Therefore, 

when equity market volatility rises, it is likely that 

an arbitrageur would wait longer before acting to 

exploit an ETF premium. As a result, the ETF 

market price would outperform the NAV price on 

days when equity market volatility is 

increasing. . . . Arbitrageurs knowingly leave 

profits on the table for a short amount of time 

because the risk or cost to trade and profit is too 

high at that time.’’). 

63Ron Delegge, ETF Bid/Ask Spreads (Apr. 23, 

2013), available at http://investius.com/2013/04/23/ 

etf-bidask-spreads/. 

64See supra note 50 and accompanying text. 65See Flash Crash Report, supra note 51, at 4–6. 

See also Morningstar ETF Report, supra note 62. 

66See Tamar Frankel, Regulation and Investors’ 

Trust in the Securities Markets, 68 Brook. L. Rev. 

439 (2002), at 448 (arguing that once investors’ trust 

is lost, they will flee the stock markets and turn to 

other types of investments that ‘‘they can see, 

evaluate and guard for themselves.’’). 

assets that may be held by the ETF, but 

only to a limited extent. For example, 

prospectus disclosures of general risks 

and investment objectives provide little 

quantitative precision about an ETF’s 

assets and risk exposures. The proposed 

quarterly portfolio disclosures would 

provide little additional quantitative 

precision as a result of portfolio 

turnover, as discussed previously. 

Consequently, variability would 

inevitably be introduced into the 

proposed model. The Commission 

believes that this may lead to a break in 

alignment between a market maker’s 

hedge portfolio and the NAV per share 

of the ETF; this could diminish the 

market maker’s ability to manage its 

risks, which, in turn, could increase its 

risk of loss.62 This greater risk of loss 

would be reflected in wider bid/ask 

spreads and result in intraday market 

prices that deviate from the NAV per 

share of the ETF, which would be 

contrary to the foundational principle 

underlying section 22(d) and rule 22c– 

1 under the Act that shareholders be 

treated equitably. 

43. The Commission also 

preliminarily believes that this potential 

price disparity could be even worse 

under times of market stress or 

volatility. Market makers would likely 

be heavily reliant on sophisticated 

algorithms to deconstruct the portfolio 

holdings of the proposed ETF in order 

to construct the hedge portfolio. During 

times of market stress or volatility, the 

Commission believes that reliance on 

these algorithms would not be sufficient 

for market making purposes in the 

proposed ETFs and the correspondence 

between the hedge portfolio and the 

NAV per share of the ETF might be 

expected to lag. This is because the 

market makers’ hedge portfolio may 

deviate significantly from the actual 

portfolio of the proposed ETF, resulting 

in greater intraday market risk to the 

market maker and a corresponding 

widening of the bid/ask spread.63 This 

would result in market prices, at which 

investors would buy and sell the ETF 

shares, not being at or close to the NAV 

per share of the ETF, which would be 

contrary to the foundational principle 

underlying section 22(d) and rule 22c– 

1 under the Act that shareholders be 

treated equitably. Accordingly, although 

some market makers supporting 

Applicants noted that they should be 

able to construct hedge portfolios that 

were closely aligned (and would remain 

aligned) to the NAV per share of the 

ETF for the domestic equity ETFs 

proposed by Applicants, the 

Commission cannot fully agree with that 

conclusion. 

44. Finally, although Applicants 

proposed a retail redemption option to 

address a significant and persistent 

deviation of market price to NAV, as 

discussed in detail above, the 

Commission preliminarily believes that 

this option is not sufficient to protect 

investors as required by the Act. 

B. Potential Disruption of Orderly 

Trading and Damage to Market 

Confidence 

45. In the absence of sufficient 

information for market makers to 

accurately assess the value of the 

underlying portfolio securities and to 

make markets in ETF shares at levels 

that are closely aligned to the NAV per 

share of the ETF, market makers are 

likely to trade in proposed ETFs with 

wide bid/ask spreads and variable 

premiums/discounts to the NAV per 

share of the ETF. This would be 

particularly the case during times of 

market stress and for active management 

strategies that might involve high 

portfolio turnover when there is a 

greater need for confidence in pricing 

signals.64 Under particularly stressful or 

volatile market conditions, the inability 

to independently and accurately value 

an ETF’s portfolio assets may cause 

market makers to withdraw from 

providing meaningful liquidity, which 

in turn can lead to the disruption of 

orderly trading in the ETF.65 The 

Commission preliminarily believes that 

a structure that may lead market makers 

to make markets in the proposed ETFs 

at prices that are not closely aligned to 

the NAV per share of the ETF is not 

necessary or appropriate in the public 

interest, nor is it consistent with the 

protection of investors or with the 

foundational principle underlying 

section 22(d) and rule 22c–1 under the 

Act that shareholders be treated 

equitably. 

46. Further, any breakdown in the 

pricing or the ability to price the 

proposed ETF may result in damage to 

market confidence in secondary trading 

of ETFs—not just in the proposed 

product, but in ETFs generally. 

Investors may exit the ETF market 

because of a loss of trust, particularly in 

actively managed ETFs, should the 

proposed ETFs fail to function in a 

manner similar to current ETFs.66 For 

this additional reason, the Commission 

preliminarily believes that it is not 

necessary or appropriate, nor in the 

public interest or consistent with the 

protection of investors and the purposes 

fairly intended by the policy and 

provisions of the Act, to grant the 

requested relief. 

* * * * * 

47. In light of the foregoing, the 

Commission remains unconvinced that 

Applicants’ proposed ETFs meet the 

standard for relief under section 6(c) of 

the Act. Accordingly, absent a request 

for a hearing that is granted by the 

Commission, the Commission intends to 

deny Applicants’ request for an 

exemption under section 6(c) of the Act 

as not necessary or appropriate in the 

public interest and as not consistent 

with the protection of investors and the 

purposes fairly intended by the policy 

and provisions of the Act. 

By the Commission. 

Kevin M. O’Neill, 

Deputy Secretary. 

[FR Doc. 2014–25438 Filed 10–24–14; 8:45 am] 

BILLING CODE 8011–01–P 

SECURITIES AND EXCHANGE 

COMMISSION 

[Investment Company Act Release No. 

31300; 812–14116] 

Precidian ETFs Trust, et al.; Notice of 

Application 

October 21, 2014. 

AGENCY: Securities and Exchange 

Commission (‘‘Commission’’). 

ACTION: Notice of an application for 

exemptive relief. 


tkelley on DSK3SPTVN1PROD with NOTICES
63972 Federal Register / Vol. 79, No. 207 / Monday, October 27, 2014 / Notices 

1The Commission first granted exemptive relief 

to operate ETFs in the early 1990s when the first 

index-based ETFs were developed. See SPDR Trust 

Series I, Investment Company Act Release Nos. 

18959 (Sept. 17, 1992) (notice) and 19055 (Oct. 26, 

1992) (order). 

2 15 U.S.C. 80a–6(c). 

3For this reason, the Commission finds it 

unnecessary to consider whether the application 

meets the section 17(b) and section 12(d)(1)(J) 

standards for exemptive relief. 

4 15 U.S.C. 80a–3(a); 80a–3(a)(1). 

5Section 22(d) of the Act prohibits a dealer from 

selling a redeemable security that is being offered 

to the public by or through an underwriter other 

than at a current public offering price described in 

the fund’s prospectus. Rule 22c–1 under the Act 

requires open-end funds, their principal 

underwriters, and dealers in fund shares (and 

certain others) to sell and redeem fund shares at a 

price based on the current NAV next computed 

after receipt of an order to buy or redeem. Together, 

these provisions are designed to require that fund 

shareholders be treated equitably when buying and 

selling their fund shares. 

6This stems from section 22(d) of the Act, which 

in effect fixes the prices at which redeemable 

securities, including open-end shares, are sold. The 

result is a system that precludes dealers from 

making a secondary market in open-end shares. 

7This has been a required representation in all 

ETF orders since the Commission issued the first 

order. See supra note 1. 

SUMMARY OF APPLICATION: Applicants 

request an order under section 6(c) of 

the Investment Company Act of 1940 

(‘‘Act’’) for an exemption from sections 

2(a)(32), 5(a)(1), 22(d) and 22(e) of the 

Act and rule 22c–1 under the Act, under 

sections 6(c) and 17(b) of the Act for an 

exemption from sections 17(a)(1) and 

17(a)(2) of the Act, and under section 

12(d)(1)(J) of the Act for an exemption 

from sections 12(d)(1)(A) and (B) of the 

Act. If granted, the requested order 

would permit several registered openend investment companies that are 

actively managed exchange traded funds 

(each, an ‘‘ETF’’) to list and trade 

without being subject to the current 

daily portfolio transparency condition 

in actively managed ETF orders. 

APPLICANTS: Precidian ETFs Trust (the 

‘‘Trust’’), Precidian Funds LLC (the 

‘‘Adviser’’) and Foreside Fund Services, 

LLC (the ‘‘Distributor’’) (together, the 

‘‘Applicants’’). 

FILING DATES: The application was filed 

on January 25, 2013, and amended on 

February 12, 2013 and July 23, 2013. 

HEARING OR NOTIFICATION OF HEARING: 

Interested persons may request a 

hearing by writing to the Commission’s 

Secretary and serving applicants with a 

copy of the request, personally or by 

mail. Hearing requests should be 

received by the Commission by 5:30 

p.m. on November 17, 2014, and should 

be accompanied by proof of service on 

applicants, in the form of an affidavit or, 

for lawyers, a certificate of service. 

Pursuant to rule 0–5 under the Act, 

hearing requests should state the nature 

of the writer’s interest, any facts bearing 

upon the desirability of a hearing on the 

matter, the reason for the request, and 

the issues contested. Persons who wish 

to be notified of a hearing may request 

notification by writing to the 

Commission’s Secretary. Absent a 

request for a hearing that is granted by 

the Commission, the Commission 

intends to issue an order under the Act 

denying the application. 

ADDRESSES: Secretary, U.S. Securities 

and Exchange Commission, 100 F Street 

NE., Washington, DC 20549–1090. 

Applicants: c/o Precidian Funds LLC, 

350 Main Street, Suite 9, Bedminster, 

New Jersey 07921–2689. 

FOR FURTHER INFORMATION CONTACT: 

Deepak T. Pai, Senior Counsel; KayMario Vobis, Senior Counsel; or Dalia 

Osman Blass, Assistant Chief Counsel, 

at (202) 551–6821 (Division of 

Investment Management, Chief 

Counsel’s Office). 

SUPPLEMENTARY INFORMATION: The 

following is a summary of the 

application. The complete application 

may be obtained via the Commission’s 

Web site by searching for the file 

number, or an applicant using the 

Company name box, at http://

www.sec.gov/search/search.htm or by 

calling (202) 551–8090. 

I. Introduction 

1. Applicants seek to introduce a 

novel type of actively managed 

exchange-traded fund (‘‘ETF’’) that 

would not be required to disclose its 

portfolio holdings on a daily basis. Due 

to their characteristics, ETFs (including 

those proposed by Applicants) are only 

permitted to operate subject to 

Commission orders that provide 

exemptive relief from certain provisions 

of the Act and rules thereunder.1

Accordingly, Applicants seek an order 

under section 6(c) of the Act for an 

exemption from sections 2(a)(32), 

5(a)(1), 22(d) and 22(e) of the Act and 

rule 22c–1 thereunder; and under 

sections 6(c) and 17(b) of the Act 

granting an exemption from sections 

17(a)(1) and 17(a)(2) of the Act, and 

under section 12(d)(1)(J) for an 

exemption from sections 12(d)(1)(A) and 

(B) of the Act. 

2. As discussed below, the 

Commission preliminarily believes that 

Applicants’ proposed ETFs do not meet 

the standard for exemptive relief under 

section 6(c) of the Act. Section 6(c) 

allows the Commission to exempt any 

person, security, or transaction, or any 

class thereof, only ‘‘if and to the extent 

that such exemption is necessary or 

appropriate in the public interest and 

consistent with the protection of 

investors and the purposes fairly 

intended by the policy and provisions of 

[the Act].’’ 2 Accordingly, the 

Commission preliminarily intends to 

deny the application.3

II. Background 

A. Open-End Investment Companies 

and Net Asset Value 

3. The Act defines an investment 

company as an ‘‘issuer’’ of ‘‘any 

security’’ which ‘‘is or holds itself out 

as being engaged primarily . . . in the 

business of investing . . . in 

securities.’’ 4 Shares in an investment 

company represent proportionate 

interests in its investment portfolio, and 

their value fluctuates in relation to the 

changes in the value of that portfolio. 

4. The most common form of 

investment company, the ‘‘open-end’’ 

investment company or mutual fund, is 

required by law to redeem its securities 

on demand at a price approximating 

their proportionate share of the fund’s 

net asset value (‘‘NAV’’) at the time of 

redemption.5 These funds also 

continuously issue and sell new shares, 

thereby replenishing their investment 

capital. 

5. Because open-end investment 

companies are required by law to 

redeem their shares based on investors’ 

demands, shares of the funds have 

historically not traded on exchanges or 

in other secondary markets.6

B. Exemptions Under the Act for 

Actively Managed ETFs 

6. ETFs, including those proposed by 

Applicants, are a type of open-end fund. 

But unlike traditional open-end funds, 

ETFs are made available to investors 

primarily through secondary market 

transactions on exchanges. 

7. In order for this to take place, ETFs 

require various exemptions from the 

provisions of the Act and the rules 

thereunder. Critically, in granting such 

exemptions to date, the Commission has 

required that a mechanism exist to 

ensure that ETF shares would trade at 

a price that is at or close to the NAV per 

share of the ETF.7

8. Such a mechanism is essential for 

ETFs to operate because ETFs do not 

sell or redeem their individual shares at 

NAV per share as required by the Act. 

Instead, large broker-dealers that have 

contractual arrangements with an ETF 

(each, an ‘‘Authorized Participant’’) 

purchase and redeem ETF shares 

directly from the ETF, but only in large 

blocks called ‘‘creation units.’’ An 

Authorized Participant that purchases a 

creation unit of ETF shares first deposits 

with the ETF a ‘‘basket’’ of securities 


tkelley on DSK3SPTVN1PROD with NOTICES
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8See Investment Company Institute, 2014 

Investment Company Fact Book (2014) (‘‘ICI Fact 

Book’’), at 60. 9The Authorized Participant’s purchase of the 

ETF shares in the secondary market, combined with 

the sale of the redemption basket securities, may 

also create upward pressure on the price of ETF 

shares and/or downward pressure on the price of 

redemption basket securities, driving the market 

price of ETF shares and the value of the ETF’s 

portfolio holdings closer together. 

10The Authorized Participant’s purchase of the 

purchase basket securities, combined with the sale 

of ETF shares, may also create downward pressure 

on the price of ETF shares and/or upward pressure 

on the price of purchase basket securities, bringing 

the market price of ETF shares and the value of the 

ETF’s portfolio holdings closer together. 

11The condition for daily portfolio transparency 

has consistently been one of the conditions to the 

exemptive relief issued to actively managed ETFs 

by the Commission. See PowerShares Capital 

Management LLC, et al., Investment Company Act 

Release Nos. 28140 (Feb. 1, 2008) (notice) and 

28171 (Feb. 27, 2008) (order). 

12See supra note 5 and accompanying text. 

and other assets (e.g., cash) identified by 

the ETF that day, and then receives the 

creation unit of ETF shares in return for 

those assets. The basket is generally 

representative of the ETF’s portfolio and 

is equal in value to the aggregate NAV 

of ETF shares in the creation unit. After 

purchasing a creation unit, the 

Authorized Participant may sell the 

component ETF shares in secondary 

market transactions. Investors then 

purchase individual shares in the 

secondary market. The redemption 

process is the reverse of the purchase 

process: the Authorized Participant 

acquires a creation unit of ETF shares 

and redeems it for a basket of securities 

and other assets. 

9. The combination of the creation 

and redemption process with the 

secondary market trading in ETF shares 

provides arbitrage opportunities that, if 

effective, keep the market price of the 

ETF’s shares at or close to the NAV per 

share of the ETF.8 For example, if an 

ETF’s shares begin trading on national 

securities exchanges at a ‘‘discount’’ (a 

price below the NAV per share of the 

ETF), an Authorized Participant can 

purchase ETF shares in secondary 

market transactions and, after 

accumulating enough shares to 

comprise a creation unit, redeem them 

from the ETF in exchange for the more 

valuable securities in the ETF’s 

redemption basket. In addition to 

purchasing ETF shares, Authorized 

Participants also are likely to hedge 

their intraday risk. Thus, for example, 

when ETF shares are trading at a 

discount to the NAV per share of the 

ETF, an Authorized Participant may 

also simultaneously short the securities 

in the redemption basket. At the end of 

the day, the Authorized Participant will 

return the creation unit of ETF shares to 

the ETF in exchange for the ETF’s 

redemption basket of securities and 

other assets, which it will then use to 

cover its short positions. Those 

purchases reduce the supply of ETF 

shares in the market, and thus tend to 

drive up the market price of the shares 

to a level closer to the NAV per share 

of the ETF.9

10. Conversely, if the market price for 

ETF shares reflects a ‘‘premium’’ (a 

price above the NAV per share of the 

ETF), an Authorized Participant can 

deposit a basket of securities in 

exchange for the more valuable creation 

unit of ETF shares, and then sell the 

individual shares in the market to 

realize its profit. An Authorized 

Participant may also hedge its intraday 

risk when ETF shares are trading at a 

premium. Thus, for example, when the 

shares of an ETF are trading at a 

premium, an Authorized Participant 

may buy the securities in the purchase 

basket in the secondary market and sell 

short the ETF shares. At the end of the 

day, the Authorized Participant will 

deposit the purchase basket of securities 

and other assets in exchange for a 

creation unit of ETF shares, which it 

will then use to cover its short 

positions. The Authorized Participant 

will receive a profit from having paid 

less for the ETF shares than it received 

for the securities in the purchase basket. 

These transactions would increase the 

supply of ETF shares in the secondary 

market, and thus tend to drive down the 

price of ETF shares to a level closer to 

the NAV per share of the ETF.10

11. Market participants can also 

engage in arbitrage activity without 

using the creation or redemption 

processes described above. For example, 

if a market participant believes that an 

ETF is overvalued relative to its 

underlying or reference assets, the 

market participant may sell short ETF 

shares and buy the underlying or 

reference assets, wait for the trading 

prices to move toward parity, and then 

close out the positions in both the ETF 

shares and the underlying or reference 

assets to realize a profit from the relative 

movement of their trading prices. 

Similarly, a market participant could 

buy ETF shares and sell the underlying 

or reference assets in an attempt to 

profit when an ETF’s shares are trading 

at a discount to the ETF’s underlying or 

reference assets. As discussed above, the 

trading of an ETF’s shares and the ETF’s 

underlying or reference assets may bring 

the prices of the ETF’s shares and its 

portfolio assets closer together through 

market pressure. 

12. In assessing whether to grant 

exemptive relief to actively managed 

ETFs in the past, the Commission has 

required a mechanism that would keep 

the market prices of ETF shares at or 

close to the NAV per share of the ETF. 

To date, this mechanism has been 

dependent on daily portfolio 

transparency.11 This transparency 

provides market makers and other 

market participants with an important 

tool to value the ETF portfolio on an 

intraday basis, which, in turn, enables 

them to assess whether an arbitrage 

opportunity exists. It is the exercise of 

such arbitrage opportunities that keeps 

the market price of ETF shares at or 

close to the NAV per share of the ETF. 

This close tie between market price and 

NAV per share of the ETF is the 

foundation for why the prices at which 

retail investors buy and sell ETF shares 

are similar to the prices at which 

Authorized Participants are able to buy 

and redeem shares directly from the 

ETF at NAV. In granting relief from 

section 22(d) of the Act and rule 22c– 

1 under the Act, the Commission relies 

on this close tie between what retail 

investors pay and what Authorized 

Participants pay to make the finding 

that the ETF’s shareholders are being 

treated equitably when buying and 

selling shares.12 The Commission 

therefore has granted such exemptive 

relief to date only to those actively 

managed ETFs that have provided daily 

transparency of their portfolio holdings. 

III. The Application 

A. The Applicants 

13. The Trust is a statutory trust 

organized under the laws of Delaware 

and registered under the Act as an openend management investment company 

with multiple series (each, a ‘‘proposed 

ETF’’). Applicants propose to offer 15 

initial proposed ETFs, each of which 

will use a variety of active management 

strategies to meet its investment 

objectives. The proposed ETFs include 

long/short funds. 

14. The Adviser, a limited liability 

corporation organized under the laws of 

Delaware, is registered as an investment 

adviser under the Investment Advisers 

Act of 1940 (‘‘Advisers Act’’) and would 

serve as the investment adviser to the 

initial proposed ETFs. The Distributor, 

a Delaware limited liability company, is 

a registered broker under the Securities 

Exchange Act of 1934, as amended. 

B. Applicants’ Proposal 

15. Applicants seek exemptive relief 

under section 6(c) of the Act to allow 

them to introduce several actively 

managed ETFs that would not disclose 

their portfolio holdings on a daily basis. 


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13Application at 20. See also Murray Coleman, 

Could a Stock ETF Cloak its Portfolio (May 7, 2012), 

available at http://online.wsj.com/news/articles/

SB100014240527023044327045773482610

39833588 (noting that if traders can identify the 

shares in which a fund manager is building a 

position, they can start buying the shares ahead of 

the manager and drive up the price while the 

manager is still buying the stock). 

14Shareholder reports, including a schedule of 

portfolio holdings, must be transmitted to 

shareholders semi-annually, within 60 days of the 

end of the second and fourth fiscal quarters. See 

Rule 30e–1. A complete schedule of portfolio 

holdings must be filed with the Commission on 

Form N–CSR within 10 days of the transmission of 

the shareholder report. See Rule 30d–1. Complete 

portfolio holdings also must be filed on Form N– 

Q within 60 days of the end of the first and third 

fiscal quarters. See Rule 30b1–5. 

15We note that the IIV is not disseminated during 

early and late trading sessions when market 

participants would still be trading the proposed 

ETFs’ shares. Therefore, there would be no pricing 

signal at all for these trades. 

16See infra note 34. 

17Application at 15. See also Matt Hougan, The 

Flaws in iNAV, 104 Exchange-Traded Funds Report 

(‘‘Hougan ETF Report’’), 5, 10 (2009). 

18Application at 15. 

19 Id. 

20See infra notes 37–42 and accompanying text. 

21Because redemptions from ETFs are often made 

in-kind, ETFs may offer certain tax efficiencies 

compared to traditional mutual funds by avoiding 

the need to sell assets and potentially experience 

a taxable event. In addition, ETFs do not bear the 

brokerage costs associated with liquidating portfolio 

instruments to meet redemption requests. We note 

that it is unclear whether Applicants’ proposed 

ETFs would experience the same in-kind benefits 

experienced by existing ETFs. The blind trust 

structure is likely to introduce additional costs 

because, among other things, the Authorized 

Participants would not be able to manage the sale 

of the securities to enhance arbitrage profits. See 

Comment Letter of Gary Gastineau, File No. SR– 

NYSEArca-2014–10 (Mar. 18, 2014) (‘‘Gastineau 

March 2014 Letter’’), at 3–5 for a discussion of the 

potential issues presented by this structure. 

22Staff in the Division of Economic and Risk 

Analysis provided advice and analyses relevant to 

the Commission’s conclusions, discussed in more 

detail below. 

23Application at 19–21. 

24According to Applicants, reinforcement 

learning is dependent on statistical arbitrage. See 

text following supra note 10. Applicants assert that 

market makers would use the proposed ETF’s 

market price, IIV and daily NAV to construct a 

hedging portfolio for the proposed ETF. The market 

makers would then engage in statistical arbitrage 

between their hedging portfolio and the shares of 

the proposed ETF—i.e., buying and selling one 

Applicants note that actively managed 

ETFs with transparent portfolios are 

susceptible to ‘‘front running’’ and ‘‘free 

riding’’ by other investors and/or 

managers which can harm, and result in 

substantial costs to, the actively 

managed ETFs.13

16. As explained below, the 

Applicants propose to operate actively 

managed ETFs that would not disclose 

their portfolio holdings on a daily basis. 

Applicants state that the relief requested 

in their application is similar to the 

relief granted in exemptive orders 

issued to existing actively managed 

ETFs, except for certain differences 

permitting the proposed ETFs to operate 

on a non-transparent basis. These 

material differences are highlighted 

below: 

a. Prospectus and Portfolio 

Disclosures: Applicants would not 

provide the daily disclosure of a 

proposed ETF’s portfolio holdings that 

is a condition in all exemptive orders 

issued to existing actively managed 

ETFs. Applicants would instead only 

provide the standard portfolio and other 

disclosures required for traditional 

mutual funds. Traditional mutual funds 

are required to disclose their portfolio 

holdings only on a quarterly basis, with 

a lag of not more than 60 days.14

b. Indicative Intraday Value: Investors 

and others acquiring the proposed ETFs’ 

shares would primarily have to rely on 

the intraday indicative value (the ‘‘IIV’’), 

which would be disseminated by an 

exchange every 15 seconds during the 

trading day,15 to assess the value of a 

proposed ETF due to the lack of 

portfolio transparency. The IIV would 

be calculated by a calculation agent who 

would receive the daily list of securities 

constituting the proposed ETF’s 

portfolio from the ETF sponsor.16 As 

acknowledged by the Applicants, the 

IIV is based on the value of the 

proposed ETF’s portfolio and is 

calculated by the calculation agent 

using the last available market quotation 

or sale price of the proposed ETF’s 

portfolio holdings.17 As further 

acknowledged by the Applicants, the 

IIV is not the NAV; rather, it is a 

reference produced by a third party 

seeking to approximate the proposed 

ETF’s underlying per share net asset 

value.18 Applicants also concede that 

the IIV is not intended as a ‘‘real-time 

NAV’’ and (unlike the NAV) would not 

include extraordinary expenses or 

liabilities booked during the day.19 As 

discussed below, an ETF’s portfolio 

could contain securities and other assets 

all (or most) of which need to be fair 

valued in order for the IIV to be 

accurate.20

c. Blind Trust Mechanism: Applicants 

propose for creation unit purchases to 

be made in cash and for redemptions to 

be effected in-kind through a ‘‘blind 

trust’’ established for each Authorized 

Participant. Applicants assert that the 

delivery of redemption securities into 

the blind trust would allow the ETF to 

retain the benefits associated with inkind redemptions,21 while shielding the 

identity of the ETF’s portfolio securities. 

Based on the standing instructions of 

the Authorized Participant, the blind 

trust would sell or otherwise manage 

the securities on behalf of the 

Authorized Participant without 

disclosing the contents of the 

underlying portfolio. 

d. Back-up Redemption Option: 

Applicants have proposed a back-up 

mechanism that would allow retail 

investors to redeem individual shares 

directly from the proposed ETFs in the 

event of a significant deviation of 

closing market price from NAV. Under 

the proposal, retail investors exercising 

the option would be subject to a 

redemption fee of up to 2% of the value 

of shares redeemed and would likely be 

charged additional brokerage 

commissions. 

IV. Analysis of the Application 

17. As noted above, the Applicants 

have sought exemptive relief under 

several provisions of the Act—each of 

which the Applicants would need to 

obtain in order to operate their proposed 

ETFs. 

18. Applicants state that the relief 

requested in their application is similar 

to the relief granted in exemptive orders 

issued to existing actively managed 

ETFs, except for certain differences 

permitting the proposed ETFs to operate 

on a non-transparent basis. 

19. As discussed below, however, the 

Commission preliminarily believes that 

the specific features proposed by the 

Applicants that would cause the 

proposed ETFs to operate without 

transparency fall far short of providing 

a suitable alternative to the arbitrage 

activity in ETF shares that is crucial to 

helping keep the market price of current 

ETF shares at or close to the NAV per 

share of the ETF.22 Accordingly, the 

Commission preliminarily believes that 

it is not in the public interest or 

consistent with the protection of 

investors or the purposes fairly intended 

by the policy and provisions of the Act 

to grant the exemptive relief under 

section 6(c) that the Applicants seek. 

A. ETF Prospectus Disclosure and IIV 

Dissemination 

20. Applicants assert that ETF 

prospectus disclosure and the 

dissemination of the IIV every 15 

seconds during the trading day would 

be sufficient to allow the arbitrage 

mechanism to function effectively after 

a few days of trading.23 Applicants 

further assert that market participants 

do not need any additional information 

about the proposed ETF’s portfolio so 

long as they are able to create 

correlations against and, over time, 

evaluate how various market factors 

affect the disseminated IIV. According 

to Applicants, this process is referred to 

as ‘‘reinforcement learning.’’ 24


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against the other during the trading day and 

evaluating the effectiveness of their hedging 

portfolio at the day’s end. Applicants further assert 

that after a few days of trading, there would be 

sufficient data for a market maker to run a statistical 

analysis that would result in the market maker’s 

spreads being tightened substantially around the 

IIV. Application at 19–21. 25For example, Form N–1A requires mutual 

funds to disclose in the prospectus and statement 

of additional information their investment 

objectives or goals, principal investment strategies, 

and the portfolio turnover rate during the most 

recent fiscal year. See, e.g., Form N–1A, Items 2 to 

4, and 9. As discussed above, mutual funds are 

required to disclose their portfolio holdings 

quarterly. See supra note 14 and accompanying 

text. 

26See David J. Abner, The ETF Handbook: How 

to Value and Trade Exchange Traded Funds (2010), 

at 90 (‘‘[s]ince stock trading now takes place in 

microseconds, a lot can happen between two 

separate 15-second quotes. Professional traders are 

not using published IIVs as a basis for trading. 

Most, if not all, desks that are trading ETFs are 

calculating their own [NAV of the ETF] based on 

real time quotes . . . that they are generating within 

their own systems.’’). See also Comment Letter of 

BGFA, File No. S7–07–08 (May 16, 2008) (‘‘BGFA 

2008 Letter’’), at n.43; and ICI Fact Book, supra note 

8, at 59. 

27The Commission previously issued a proposing 

release on a proposed rule for certain ETFs. See 

Exchange-Traded Funds, Investment Company Act 

Release No. 28193 (Mar. 11, 2008) (‘‘2008 ETF Rule 

Proposal’’). Various industry members commenting 

on the 2008 ETF Rule Proposal noted that market 

makers did not rely on the IIV because of either its 

staleness or unreliability. See, e.g., Comment Letter 

of NYSE Arca, Inc., File No. S7–07–08 (May 29, 

2008) (the exchange noted that it ‘‘is not convinced 

that the [IIV] is a meaningful pricing tool for 

investors in light of the availability of other pricing 

information. In fact, we believe that it is the 

transparency of the portfolios [sic] holdings which 

permit [sic] market makers and other professionals 

to arbitrage efficiently and not the regular 

dissemination of an [IIV]. Some market participants 

may choose to generate an [IIV] for their own use, 

using their own calculation methodology to include 

financing costs, capital costs, etc., in kind trading 

or arbitrage. Importantly, the [IIV] generated by 

professionals is in real-time and not delayed by 15 

or 60 seconds.’’); and BGFA 2008 Letter, supra note 

26, at n. 43 and n. 92. See also Matt Hougan, Ban 

iNAVs For ETFs (June 24, 2013), available at http:// 

www.indexuniverse.com/sections/blog/19037- 

hougan-ban-inavs-for-etfs.html. 

28See Comment Letter of ICI, File No. SR– 

NASDAQ–2012–117 (Nov. 8, 2012), (‘‘ICI 2012 

Letter’’), at 4. See also ICI Fact Book, supra note 8. 

29See, e.g., How To Minimize Your Cost Of 

Trading ETFs (June 22, 2009), ETF.com, available 

at http://www.etf.com/publications/

journalofindexes/joi-articles/6042-how-tominimize-your-cost-of-trading-etfs.html, at Figure 2 

and related discussion. See also ICI 2012 Letter, 

supra note 28 (‘‘Professional equity traders operate 

at speeds calculated in fractions of a second. In 

such markets, 15 seconds can be an eternity, and 

establishing an order price based on data that is 

nearly 15 seconds old could result in poor 

execution.’’). 

30 In particularly volatile markets, the 

dissemination lag of IIV values (i.e., every 15 

seconds) may misrepresent the actual value of the 

ETF. See Understanding iNAV, ETF.com, available 

at http://www.etf.com/etf-education-center/21028- 

understanding-inav.html; Gary L. Gastineau, 

Exchange-Traded Funds Manual, Second Edition 

(2010), at 200–202. 

31See, e.g., ICI 2012 Letter, supra note 28. 

32See, e.g., ICI 2012 Letter, supra note 28. See 

also Gastineau March 2014 Letter, supra note 21, at 

10, for a more detailed discussion of why the IIV 

would at best be a ‘‘lagging indicator of actual 

portfolio values’’ during times of rapid market 

movement. 

33An IIV that is disseminated at more frequent 

intervals could present a different set of problems, 

as it may enable third parties to reverse engineer the 

underlying portfolio using data analysis. Therefore, 

changing the frequency of dissemination would not 

appear to be a viable option to the extent 

Applicants’ objective is to prevent disclosure of the 

proposed ETF’s portfolio. See also infra note 36 and 

accompanying text. 

34See, e.g., ICI 2012 Letter, supra note 28 

(‘‘[M]any parties participate in the calculation, 

publication, and dissemination of [IIV]. The ETF 

sponsor provides an independent calculation agent 

with the daily list of securities constituting an 

ETF’s creation basket (which for U.S. equity ETFs 

is typically, but not always, a pro rata slice of the 

ETF’s portfolio). The calculation agent separately 

obtains market pricing information for each of the 

component securities from a third party source, 

such as the exchange or a pricing vendor, and 

calculates the estimated per-share value of an ETF 

share. This process creates several opportunities for 

errors: For example, an ETF may report a basket 

inaccurately; a calculation agent may receive faulty 

data from a pricing vendor; or an error may be made 

in the calculation process. We understand that such 

errors are not infrequent.’’ [emphasis added]). 

35Applicants explicitly disclaim making any 

warranty by the ETFs as to the accuracy of the IIV. 

The Adviser would merely use ‘‘commercially 

reasonable efforts to assure that the calculation 

agent has an accurate listing of all securities in each 

[f]und’s portfolio as of the beginning of trading on 

each day the [f]und is traded.’’ Similarly, 

‘‘[a]lthough the calculation agent will not guarantee 

the accuracy of the IIV, the contract with the 

calculation agent will require that it use 

Continued 

21. ETF prospectus disclosure will 

not assist the arbitrage mechanism 

because such disclosure does not 

contain any material real-time 

information necessary to creating or 

facilitating effective arbitrage. Actively 

managed funds generally include very 

broad investment objectives and 

strategies in order to provide investment 

advisers with the maximum flexibility 

possible in managing the portfolio, and 

do not include more specific, current 

information about a fund’s portfolio 

holdings.25 The Commission 

preliminarily believes that it would be 

difficult, if not impossible, for market 

participants to discern sufficient useful 

information from such broad 

disclosures. Therefore, the lack of more 

specific information with respect to the 

proposed ETF’s investment objectives or 

principal investment strategies may not 

enable market makers to effectively 

assess whether real-time arbitrage 

opportunities in ETF shares exist and 

may discourage them from making 

markets in ETF shares that would keep 

the share prices at or close to the NAV 

per share of the ETF—a condition that 

may be exacerbated during times of 

market stress. 

22. Dissemination of the IIV at 15 

second intervals throughout the trading 

day does not fill this information void. 

Today, market makers calculate their 

own NAV per share of the ETF with 

proprietary algorithms that use an ETF’s 

daily portfolio disclosure and available 

pricing information about the assets 

held in the ETF’s portfolio.26 They 

generally use the IIV, if at all, as a 

secondary or tertiary check on the 

values that their proprietary algorithms 

generate. If the daily portfolio holdings 

for the proposed ETFs are not available 

for market makers to calculate current 

values of a proposed ETF, they will be 

reliant principally on the IIV given the 

limitations of the prospectus and 

quarterly portfolio disclosures. Even 

though the IIV continues to be 

disseminated in conjunction with the 

full portfolio holdings and basket of 

existing ETFs, its reliability as a primary 

pricing signal for the proposed ETFs is 

questionable for the reasons discussed 

below. 

23. The IIV is stale data. Unlike 

market maker proprietary algorithms, 

which rely on portfolio transparency 

and provide market makers with realtime data to effectively trade in today’s 

fast moving markets, IIV dissemination 

frequency is inadequate for purposes of 

making efficient markets in ETFs.27

Market makers operate at speeds 

calculated in fractions of a second.28 In 

today’s markets, 15 seconds is too long 

for purposes of efficient market making 

and could result in poor execution.29

Because an ETF is a derivative security, 

its current value changes every time the 

value of any underlying component of 

the ETF portfolio changes.30 Therefore, 

the IIV for a more frequently traded 

component security might not 

effectively take into account the full 

trading activity for that security, despite 

being available every 15 seconds. For 

example, a large buy order for a 

component security held by the 

proposed ETF could temporarily spike 

the price of that security and, therefore, 

inflate the proposed ETF’s 

contemporaneous IIV calculation.31 The 

IIV for the proposed ETF cannot adjust 

for such variations, whereas the NAV 

would.32 Therefore, relying on a stale 

IIV as a primary pricing signal for 

market making in Applicants’ proposed 

ETFs would not result in an effective 

arbitrage mechanism.33

24. The IIV is not subject to 

meaningful standards. Because there are 

no uniform methodology requirements, 

the IIV can be calculated in different 

ways rendering it potentially arbitrary 

and inconsistent.34 Also, Applicants 

acknowledge that no party has agreed to 

take responsibility for the accuracy of 

IIV calculation.35 Therefore, the 


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commercially reasonable efforts to calculate the IIV 

correctly. . . .’’ Application at 15. 

36As is the case with more frequent 

dissemination, an IIV that is sufficiently accurate 

and precise may also enable third parties to reverse 

engineer the underlying portfolio using data 

analysis. Such an ETF would thus once again 

become vulnerable to front running if its portfolio 

can be reverse engineered by others. See Gastineau 

March 2014 Letter, supra note 21, at 15. 

37See Hougan ETF Report, supra note 17. NAV 

includes fair value pricing, and with daily portfolio 

disclosure, market makers can estimate fair value 

on their own for the holdings of current ETFs. 

38See, e.g., ICI 2012 Letter, supra note 28. 

39See Gastineau March 2014 Letter, supra note 21 

(noting that an exchange may institute a trading halt 

in a stock to address a significant order imbalance 

or in connection with release of important company 

news). 

40See Securities Exchange Act Release No. 34– 

71588 (Feb. 20, 2014), File No. SR–NYSEArca– 

2014–10. 

41 15 U.S.C. 80a–2(a)(41)(B). See also Independent 

Directors Council, Fundamentals for Newer 

Directors (Feb. 2014), available at http://

fundamentals.idc.org/specific/specific_pricing, at 

27. 

42ETF sponsors seek to minimize exposure to 

assets that could impact this deviation because they 

can make arbitrage opportunities more difficult to 

evaluate. See Comment Letter of ICI, File No. S7– 

07–08 (May 19, 2008). See also Comment Letter of 

The American Stock Exchange LLC, File No. S7– 

20–01 (Mar. 5, 2002) (‘‘Ultimately it is in the 

interest of the sponsor and investment adviser to 

provide for effective arbitrage opportunities. It is 

unlikely that an . . . ETF sponsor would be able to 

convince the critical market participants such as 

specialists, market makers, arbitragers and other 

Authorized Participants to support a product that 

contained illiquid securities to a degree that would 

affect the liquidity of the ETF, making it difficult 

to price, trade and hedge, ultimately leading to its 

failure in the marketplace.’’). 

43Such factors would include the market, asset 

class, sector and other risk factors. Market makers 

would need to estimate these exposures for a 

proposed ETF in order to construct hedging 

portfolios. 

44This calls into question the reinforcement 

learning process which may not perform adequately 

during periods of heightened market volatility. See 

Sanmay Das, Intelligent Market-Making in Artificial 

Financial Markets, Massachusetts Institute of 

Technology—Artificial Intelligence Laboratory, AI 

Technical Report 2003–005, at 37. 

45A commonly accepted assumption in economic 

models of market making is that market makers’ 

bid-ask spreads compensate them for a number of 

costs including the risk they bear in their positions. 

See Maureen O’Hara, Market Microstructure 

Theory, First Edition (1998), at 35. Therefore, 

greater tracking errors in hedging portfolios for the 

proposed ETFs will likely result in higher bid-ask 

spreads and greater tracking errors between 

intraday ETF prices and the NAV of the ETF. 

46 In contrast, turnover would introduce no such 

uncertainty in ETFs with daily portfolio disclosure 

as the end-of-day NAV would be marked to the 

previously disclosed portfolio, which is known by 

market makers. 

47Applicants are seeking relief to launch, among 

others, long/short equity proposed ETFs. These 

types of funds have a higher portfolio turnover on 

average than that of actively managed equity funds. 

See Jing-Zhi Huang and Ying Wang, Should 

Investors Invest in Hedge Fund-Like Mutual Funds? 

Evidence from the 2007 Financial Crisis, 22 J. of 

Financial Intermediation 482 (2013), available at 

http://dx.doi.org/10.1016/j.jfi.2012.11.004, at 486– 

487 (finding that average turnover across 130/30 

equity mutual funds was 196% from June 2003 

until December 2009 versus less than 70% across 

all actively managed mutual funds in a comparable 

time period). These proposed ETFs also could have 

more thinly traded securities that could be more 

susceptible to price volatility during stressed 

market conditions. Therefore, it may be difficult for 

market makers to construct appropriate hedging 

portfolios from the IIV, making the proposed ETFs 

also likely to have higher tracking errors and bidask spreads. 

48See, e.g., Report to the Joint Advisory 

Committee on Emerging Regulatory Issues, Staffs of 

the CFTC and SEC (Sept. 20, 2010) (‘‘Flash Crash 

Report’’), at 4–6 (noting that buy-side and sell-side 

interest returned only after market makers were able 

to verify the integrity of their data and systems and 

that they had to assess the risks of continuing to 

trade during the events of May 6, 2010). 

49See supra notes 27–36 and accompanying text. 

Commission’s preliminary conclusion is 

that the IIV calculation methodology is 

not appropriate for the IIV to be used as 

a primary pricing signal because it is 

potentially unreliable and susceptible to 

errors.36

25. The IIV would be inaccurate for 

certain securities and asset classes. 

Because the IIV is constructed using last 

available market quotations or sale 

prices and not fair value prices for the 

underlying assets, it can be inaccurate.37

For example, as some securities do not 

trade frequently, the IIV would reflect 

the last quoted or sale price which 

could be stale and no longer reflect their 

current value.38 Other securities may 

not have yet opened for trading on a 

particular trading day or may be subject 

to an intraday interruption in trading.39

26. Applicants note that up to 15% of 

the proposed ETFs’ total assets could be 

in illiquid securities.40 Illiquid 

securities often fall within the category 

of securities for which there is no 

readily available market quotation and 

their fair value must be determined in 

good faith by the fund’s directors.41

Therefore, a significant amount of 

illiquid securities in a proposed ETF’s 

portfolio could exacerbate the deviation 

between the IIV and the NAV per share 

of the ETF because the accurate value of 

illiquid securities is determined by 

current fair valuation (reflected in the 

NAV) rather than use of stale pricing 

data (reflected in the IIV).42

27. IIV inaccuracies can increase ETF 

tracking errors. Errors in the IIV will 

likely lead to errors in estimating the 

factors that a market maker must 

consider when valuing a proposed ETF 

and constructing a hedging portfolio.43

Therefore, market makers may not be 

able to construct accurate hedging 

portfolios for the ETF shares.44 This 

would increase the tracking error 

associated with the hedging portfolios 

described above. As a result, tracking 

errors between intraday ETF prices and 

NAV per share of the proposed ETF 

would also likely increase because 

greater tracking errors in hedging 

portfolios would expose the market 

maker’s position to greater risk.45

28. In addition, it may be more 

difficult for market makers to construct 

appropriate hedging portfolios from the 

IIV for proposed ETFs with higher 

portfolio turnover. In particular, 

changing portfolio allocations can cause 

the factors that a market maker must 

consider when valuing a proposed ETF 

and constructing a hedging portfolio to 

fluctuate more rapidly. This would in 

turn increase uncertainty around the 

market maker’s estimates of these 

factors.46 Therefore, proposed ETFs 

with more complex investment 

strategies involving dynamic factors will 

likely have higher tracking errors and 

bid-ask spreads if there is lack of 

sufficient information for market 

participants to construct tight hedges.47

29. IIV inaccuracies can increase 

during periods of market stress or 

volatility. Market stress can reduce 

liquidity in certain assets and 

consequently increase errors in IIV as 

the portfolio becomes increasingly 

illiquid and current market prices 

become more difficult to determine. In 

addition, volatility can increase errors 

around prices used in IIV calculations 

as volatility can increase the movement 

of prices. 

30. In stressed markets, confidence in 

the pricing of (and in turn, the 

knowledge of) the ETF portfolio 

becomes increasingly important for 

market makers to continue to quote 

prices in ETF shares.48 By itself, the IIV 

of a proposed ETF likely will not instill 

such confidence in a proposed ETF’s 

pricing because, as discussed above, the 

IIV is potentially unreliable and 

susceptible to errors.49 Nevertheless, a 

market maker that questions the current 

market price or IIV for an ETF can check 

those numbers against the NAV per 

share of the ETF output from its 

proprietary algorithm if the ETF has a 

fully transparent portfolio. That same 

market maker, however, would not be 

able to run a similar cross-check on 

those figures against a non-transparent 

ETF like the ones proposed by 

Applicants. Due to the inherent 

weaknesses of the IIV as a stand-alone 

metric, Applicants’ proposal (which 

relies heavily upon the IIV as a 

substitute for full portfolio 

transparency) likely will not offer 

enough information about the 

underlying portfolio. As discussed 

below, this, in turn, likely would 

discourage market makers from making 

markets that would keep the market 

price for the proposed ETF’s shares at or 


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50See infra Section V. 

51Antti Petajisto, Active Share and Mutual Fund 

Performance, 69 Financial Analysts Journal 73 

(2013), available at http://www.cfapubs.org/doi/

pdf/10.2469/faj.v69.n4.7, at 83. The study found 

that annual turnover across U.S. all-equity mutual 

funds is 87%. As a result, approximately 14% of the 

portfolio changes over the 60 days following the 

portfolio disclosure (prorating annual turnover of 

87% for 60 days) and an additional 22% of the 

portfolio changes over the course of the following 

quarter (prorating annual turnover of 87% for three 

months). Therefore, there may be significant 

tracking errors between an ETF’s current portfolio 

holdings and its prior quarterly portfolio disclosure. 

52Application at 12. 

53An economically rational investor who seeks to 

exercise the option is likely not to redeem until a 

trading discount to IIV in the secondary market 

exceeds the costs to redeem (i.e., the redemption fee 

plus the brokerage charges). Given that typical bid/ 

ask spreads for ETFs with underlying diversified 

domestic equity holdings average 4 basis points, a 

redemption fee set at 2% will cost the investor 200 

basis points (not including brokerage charges) to 

exit the proposed ETFs. See Antti Petajisto, 

Inefficiencies in the Pricing of Exchange-Traded 

Funds (Sept. 20, 2013), available at http://

papers.ssrn.com/sol3/papers.cfm?abstract_

id=2000336, at Table III. This assumes that the 

investor has the information necessary (IIV, bid 

price for the shares, redemption fee, brokerage 

charges) to make the determination of whether to 

redeem directly from the proposed ETFs or sell on 

the market. See generally, Matt Hougan, The Flaws 

in the iNAV, Exchange-Traded Funds Report (July 

2009), at 5 (noting that investors would have to 

have deep quantitative experience to create models 

to see if they were getting fair prices on ETF trades 

today); and John Beshears, James Choi, David 

Laibson, and Brigitte C. Madrian, How Does 

Simplified Disclosure Affect Individuals’ Mutual 

Fund Choices?, in Explorations in the Economics of 

Aging, edited by David A. Wise (2011) (noting that 

many retail investors lack the ability to perform 

even elementary calculations to compare 

investment options with differing sales fees). 

54Applicants proposed the redemption option 

described above in response to the staff’s 

suggestion. The Commission preliminarily believes 

that the inherent structural flaw of the proposed 

ETFs—i.e., the potential lack of an effective 

arbitrage mechanism—cannot be solved by the 

proposed fail-safe mechanism. 55See supra note 5. 

close to the NAV per share of the ETF, 

particularly under stressed market 

conditions when the need for real-time 

and verifiable pricing information 

becomes more acute.50

31. Accordingly, the Commission’s 

preliminary conclusion is that use of the 

IIV as a primary pricing signal for 

market making in Applicants’ proposed 

ETFs would not result in an effective 

arbitrage mechanism. 

B. Quarterly Release of Portfolio 

Holdings 

32. Applicants also propose providing 

their portfolio holdings disclosures on a 

quarterly basis, with a lag of not more 

than 60 days. But such disclosures 

would quickly lose their relevance for 

purposes of valuing or hedging the 

proposed ETFs because the content of 

their portfolios can change on a daily 

basis. This problem is heightened for 

ETFs with active management strategies 

that involve high portfolio turnover and 

alternative asset classes.51 Again, this 

may discourage market makers from 

making markets that would keep the 

market price for the proposed ETF’s 

shares at or close to the NAV per share 

of the ETF, particularly during times of 

market stress when the need for realtime pricing information becomes more 

acute. 

C. Back-Up Redemption Option 

33. In light of concerns about the 

effect on retail investors if the arbitrage 

mechanism failed to keep market prices 

at or close to the NAV of the proposed 

ETFs, Applicants proposed a 

redemption option that, in their view, 

would act as a ‘‘fail-safe’’ mechanism in 

the event of a significant deviation of 

closing market price from NAV. The 

redemption option would permit retail 

investors (but not institutional or other 

investors) to redeem their shares, in less 

than creation unit size, for cash directly 

from the proposed ETFs at NAV as of 

4:00 p.m. (Eastern Time) each trading 

day.52 For the reasons discussed below, 

the Commission preliminarily believes 

that this redemption option does not 

remedy the defects with Applicants’ 

proposal outlined above such that 

exemptive relief would be appropriate. 

34. Under the proposal, retail 

investors exercising the redemption 

option would be subject to redemption 

and brokerage fees, which would likely 

discourage use of the option. 

Specifically, retail investors exercising 

the redemption option would be subject 

to a redemption fee of up to 2% of the 

value of shares redeemed. In addition, 

retail investors would likely be charged 

additional brokerage commissions to 

exercise the option. These fees and costs 

may dissuade retail investors from 

exercising a redemption option meant to 

provide retail investors with the ability 

to transact with the ETF on an equal 

footing with the Authorized 

Participants.53

35. But even if Applicants were able 

to address the Commission’s concerns 

about the retail redemption option, this 

would not address the Commission’s 

more fundamental concerns about 

Applicants’ proposal. As discussed 

above, Applicants are proposing an ETF 

model that the Commission 

preliminarily believes would not have a 

sufficiently effective arbitrage 

mechanism to consistently produce a 

secondary market price for investors 

that would approximate NAV per share 

of the ETF. The presence of a back-up 

retail redemption option does not cure 

the inherently flawed structure of the 

proposed ETFs here.54

V. The Commission’s Preliminary View 

36. As discussed above, the 

Commission preliminarily believes that 

Applicants have not provided an 

adequate substitute for portfolio 

transparency such that the proposed 

ETFs would consistently trade at or 

close to NAV. A close tie between 

market price and NAV per share of the 

ETF is the foundation for why the prices 

at which retail investors buy and sell 

ETF shares are similar to the prices at 

which Authorized Participants are able 

to buy and redeem shares directly from 

the ETF at NAV. This close tie between 

the prices paid by retail investors and 

Authorized Participants is important 

because section 22(d) and rule 22c–1 

under the Act are designed to require 

that all fund shareholders be treated 

equitably when buying and selling their 

fund shares.55 In fact, in granting relief 

from section 22(d) and rule 22c–1 under 

the Act, the Commission has relied on 

this close tie between what retail 

investors pay and what Authorized 

Participants pay to make the finding 

that the ETF’s shareholders are being 

treated equitably when buying and 

selling shares. 

37. The lack of portfolio transparency 

or an adequate substitute for portfolio 

transparency coupled with a potentially 

deficient back-up mechanism presents a 

significant risk that the market prices of 

ETF shares may materially deviate from 

the NAV per share of the ETF— 

particularly in times of market stress 

when the need for verifiable pricing 

information becomes more acute. This 

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. 

A. Substantial Costs to Investors 

38. One of the primary benefits of 

current ETFs is that investors are 

generally able to obtain a similar 

economic experience to investors in 

traditional open-end funds (i.e., price at 

or close to NAV), but without certain of 

the costs associated with such funds 

(e.g., transfer agency fees). The 

Commission preliminarily believes the 

proposed ETFs would not provide either 

element of this benefit if, as the 

Commission anticipates, the arbitrage 

mechanism does not function properly. 

A breakdown in the arbitrage 

mechanism could result in material 

deviations between market price and 


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56Commission staff met with market makers 

invited by the Applicants on December 4, 2013. 57ETF market makers commonly use 

representative hedging portfolios instead of trading 

in basket securities because they may be easier to 

implement or more cost effective. They do this to 

offset market exposures as they build short or long 

positions in the ETFs intraday. The market maker 

will earn profits to the extent its hedge portfolio 

deviates from the NAV per share. See Gastineau 

March 2014 Letter, supra note 21, at 6. 

58See Examining the Exchange-Traded Nature of 

Exchange-Traded Funds, Morningstar ETF Research 

(Feb. 11, 2013) (‘‘Morningstar ETF Report’’), at 21 

(‘‘To consider conducting an arbitrage transaction, 

arbitrageurs must be fairly confident that they will 

receive a return commensurate with the level of risk 

they are assuming. Therefore, it is likely that 

intraday changes to volatility (that is, risk) cause 

arbitrageurs to become more or less confident when 

transacting in the equity market for purposes of 

arbitrage and thus cause premiums or discounts to 

occur in the short term. . . . From the perspective 

of an arbitrageur, increased equity market volatility 

implies that the value of purchased equities relative 

to the value of the ETF’s shares is at greater risk 

to fall and thus increases the potential that arbitrage 

trade will be less profitable, if at all. Therefore, 

when equity market volatility rises, it is likely that 

an arbitrageur would wait longer before acting to 

exploit an ETF premium. As a result, the ETF 

market price would outperform the NAV price on 

days when equity market volatility is increasing. 

. . . Arbitrageurs knowingly leave profits on the 

table for a short amount of time because the risk or 

cost to trade and profit is too high at that time.’’). 

59Ron Delegge, ETF Bid/Ask Spreads (Apr. 23, 

2013), available at http://investius.com/2013/04/23/ 

etf-bidask-spreads/. 

60See supra note 47 and accompanying text. 61See Flash Crash Report, supra note 48, at 4–6. 

See also Morningstar ETF Report, supra note 58. 

NAV per share of the ETF. Such 

deviations can hurt an investor. For 

example, if an investor places a buy 

order and the ETF is trading at a 

premium, this would result in a lower 

return for the investor as opposed to if 

the investor had bought the ETF when 

its prices were at or close to the NAV 

per share of the ETF or at a discount. As 

discussed above, the arbitrage 

mechanism inherent in the ETF 

structure keeps these differences small. 

39. In this regard, the Commission 

finds it significant that market makers 

for Applicants expressed some 

skepticism during meetings with 

Commission staff that the IIV could be 

used as the primary pricing signal for 

ETFs with active management strategies 

that might involve high portfolio 

turnover.56 They indicated that they 

would likely use the pieces of 

information provided by the Applicants 

(IIV, quarterly portfolio holdings 

disclosure and prospectus disclosure) to 

construct hedge portfolios using 

sophisticated algorithms.57 Their ability 

to construct hedge portfolios that are 

generally predictive of the portfolio 

holdings of the ETF is critical to their 

management of their exposure to the 

ETF. If there is a break in the alignment 

between the market makers’ hedge 

portfolios and the NAV per share of the 

ETF, the market makers’ risk of loss 

increases. The greater the risk of loss, 

the more the market makers will seek to 

cover that risk by quoting wider price 

spreads of the proposed ETFs. This 

would result in market prices, at which 

investors would buy and sell the ETF 

shares, not being at or close to the NAV 

per share of the ETF, which would be 

contrary to the foundational principle 

underlying section 22(d) and rule 22c– 

1 under the Act that shareholders be 

treated equitably. 

40. The Commission preliminarily 

believes that, even under normal market 

conditions, market makers could be 

unable to deconstruct the portfolio 

holdings of a proposed ETF with 

sufficient accuracy in order to construct 

a hedge portfolio that is closely aligned 

to the NAV per share of the ETF. The 

proposed disclosures by the Applicants 

would likely be useful in narrowing 

down the pool of securities and other 

assets that may be held by the ETF, but 

only to a limited extent. For example, 

prospectus disclosures of general risks 

and investment objectives provide little 

quantitative precision about an ETF’s 

assets and risk exposures. The proposed 

quarterly portfolio disclosures would 

provide little additional quantitative 

precision as a result of portfolio 

turnover, as discussed previously. 

Consequently, variability would 

inevitably be introduced into the 

proposed model. The Commission 

believes that this may lead to a break in 

alignment between a market maker’s 

hedge portfolio and the NAV per share 

of the ETF; this could diminish the 

market maker’s ability to manage its 

risks, which, in turn, could increase its 

risk of loss.58 This greater risk of loss 

would be reflected in wider bid/ask 

spreads and result in intraday market 

prices that deviate from the NAV per 

share of the ETF, which would be 

contrary to the foundational principle 

underlying section 22(d) and rule 22c– 

1 under the Act that shareholders be 

treated equitably. 

41. The Commission also 

preliminarily believes that this potential 

price disparity could be even worse 

under times of market stress or 

volatility. Market makers would likely 

be heavily reliant on sophisticated 

algorithms to deconstruct the portfolio 

holdings of the proposed ETF in order 

to construct the hedge portfolio. During 

times of market stress or volatility, the 

Commission believes that reliance on 

these algorithms would not be sufficient 

for market making purposes in the 

proposed ETFs and the correspondence 

between the hedge portfolio and the 

NAV per share of the ETF might be 

expected to lag. This is because the 

market makers’ hedge portfolio may 

deviate significantly from the actual 

portfolio of the proposed ETF, resulting 

in greater intraday market risk to the 

market maker and a corresponding 

widening of the bid/ask spread.59 This 

would result in market prices, at which 

investors would buy and sell the ETF 

shares, not being at or close to the NAV 

per share of the ETF, which would be 

contrary to the foundational principle 

underlying section 22(d) and rule 22c– 

1 under the Act that shareholders be 

treated equitably. Accordingly, although 

some market makers supporting 

Applicants noted that they should be 

able to construct hedge portfolios that 

were closely aligned (and would remain 

aligned) to the NAV per share of the 

ETF for the domestic equity ETFs 

proposed by Applicants, the 

Commission cannot fully agree with that 

conclusion. 

42. Finally, although Applicants 

proposed a retail redemption option to 

address a significant deviation of market 

price to NAV, as discussed in detail 

above, the Commission preliminarily 

believes that this option is not sufficient 

to protect investors as required by the 

Act. 

B. Potential Disruption of Orderly 

Trading and Damage to Market 

Confidence 

43. In the absence of sufficient 

information for market makers to 

accurately assess the value of the 

underlying portfolio securities and to 

make markets in ETF shares at levels 

that are closely aligned to the NAV per 

share of the ETF, market makers are 

likely to trade in proposed ETFs with 

wide bid/ask spreads and variable 

premiums/discounts to the NAV per 

share of the ETF. This would be 

particularly the case during times of 

market stress and for active management 

strategies that might involve high 

portfolio turnover when there is a 

greater need for confidence in pricing 

signals.60 Under particularly stressful or 

volatile market conditions, the inability 

to independently and accurately value 

an ETF’s portfolio assets may cause 

market makers to withdraw from 

providing meaningful liquidity, which 

in turn can lead to the disruption of 

orderly trading in the ETF.61 The 

Commission preliminarily believes that 

a structure that may lead market makers 

to make markets in the proposed ETFs 

at prices that are not closely aligned to 

the NAV per share of the ETF is not 

necessary or appropriate in the public 

interest, nor is it consistent with the 

protection of investors or with the 


tkelley on DSK3SPTVN1PROD with NOTICES
Federal Register / Vol. 79, No. 207 / Monday, October 27, 2014 / Notices 63979 

62See Tamar Frankel, Regulation and Investors’ 

Trust in the Securities Markets, 68 Brook. L. Rev. 

439 (2002), at 448 (arguing that once investors’ trust 

is lost, they will flee the stock markets and turn to 

other types of investments that ‘‘they can see, 

evaluate and guard for themselves.’’). 

1 15 U.S.C. 78s(b)(1). 

2 17 CFR 240.19b–4. 

3MIAX Express Interface is a connection to MIAX 

systems that enables Market Makers to submit 

electronic quotes to MIAX. 

4Where there is an imbalance at the price at 

which the maximum number of contracts can trade 

that is also at or within the highest valid width 

quote bid and lowest valid width quote offer, the 

System will calculate an Expanded Quote Range 

(‘‘EQR’’). The EQR will be recalculated any time a 

Route Timer or Imbalance Timer expires if material 

conditions of the market (imbalance size, ABBO 

price or size, liquidity price or size, etc.) have 

changed during the timer. Once calculated, the EQR 

will represent the limits of the range in which 

transactions may occur during the opening process. 

See Exchange Rule 503(f)(5). 

5After the Exchange has determined to end a 

trading system halt, the System will broadcast to 

subscribers of the Exchange’s data feeds, a Post-Halt 

Notification. See Exchange Rule 504(d). 

6 If a Market Maker quote was all or part of the 

MIAX Best Bid or Offer (‘‘MBBO’’) and the Market 

Maker’s quote was exhausted by the partial 

execution of the initiating order, the System will 

pause the market for a time period not to exceed 

one second to allow additional orders or quotes 

refreshing the liquidity at the MBBO to be received 

(‘‘liquidity refresh pause’’). See Exchange Rule 

515(c)(2). 

7MIAX Express Interface is a connection to MIAX 

systems that enables Market Makers to submit 

electronic quotes to MIAX. 

foundational principle underlying 

section 22(d) and rule 22c–1 under the 

Act that shareholders be treated 

equitably. 

44. Further, any breakdown in the 

pricing or the ability to price the 

proposed ETF may result in damage to 

market confidence in secondary trading 

of ETFs—not just in the proposed 

product, but in ETFs generally. 

Investors may exit the ETF market 

because of a loss of trust, particularly in 

actively managed ETFs, should the 

proposed ETFs fail to function in a 

manner similar to current ETFs.62 For 

this additional reason, the Commission 

preliminarily believes that it is not 

necessary or appropriate, nor in the 

public interest or consistent with the 

protection of investors and the purposes 

fairly intended by the policy and 

provisions of the Act, to grant the 

requested relief. 

* * * * * 

45. In light of the foregoing, the 

Commission remains unconvinced that 

Applicants’ proposed ETFs meet the 

standard for relief under section 6(c) of 

the Act. Accordingly, absent a request 

for a hearing that is granted by the 

Commission, the Commission intends to 

deny Applicants’ request for an 

exemption under section 6(c) of the Act 

as not necessary or appropriate in the 

public interest and as not consistent 

with the protection of investors and the 

purposes fairly intended by the policy 

and provisions of the Act. 

By the Commission. 

Kevin M. O’Neill, 

Deputy Secretary. 

[FR Doc. 2014–25437 Filed 10–24–14; 8:45 am] 

BILLING CODE 8011–01–P 

SECURITIES AND EXCHANGE 

COMMISSION 

[Release No. 34–73395; File No. SR–MIAX– 

2014–53] 

Self-Regulatory Organizations; Miami 

International Securities Exchange LLC; 

Notice of Filing and Immediate 

Effectiveness of a Proposed Rule 

Change To Amend the MIAX Top of 

Market (‘‘ToM’’) and AIS Data Feeds 

October 21, 2014. 

Pursuant to the provisions of Section 

19(b)(1) of the Securities Exchange Act 

of 1934 (‘‘Act’’) 1 and Rule 19b–4 

thereunder,2 notice is hereby given that 

on October 6, 2014, Miami International 

Securities Exchange LLC (‘‘MIAX’’ or 

‘‘Exchange’’) filed with the Securities 

and Exchange Commission 

(‘‘Commission’’) a proposed rule change 

as described in Items I, II, and III below, 

which Items have been prepared by the 

Exchange. The Commission is 

publishing this notice to solicit 

comments on the proposed rule change 

from interested persons. 

I. Self-Regulatory Organization’s 

Statement of the Terms of Substance of 

the Proposed Rule Change 

The Exchange is filing a proposal to 

amend the MIAX Top of Market 

(‘‘ToM’’) and AIS data feeds. 

II. Self-Regulatory Organization’s 

Statement of the Purpose of, and 

Statutory Basis for, the Proposed Rule 

Change 

In its filing with the Commission, the 

Exchange included statements 

concerning the purpose of and basis for 

the proposed rule change and discussed 

any comments it received on the 

proposed rule change. The text of these 

statements may be examined at the 

places specified in Item IV below. The 

Exchange has prepared summaries, set 

forth in sections A, B, and C below, of 

the most significant aspects of such 

statements. 

A. Self-Regulatory Organization’s 

Statement of the Purpose of, and 

Statutory Basis for, the Proposed Rule 

Change 

1. Purpose 

The Exchange proposes to amend the 

MIAX Top of Market (‘‘ToM’’) market 

data feed, the MIAX Express Interface 

(‘‘MEI’’) connectivity service,3 and 

Administrative Information Subscriber 

(‘‘AIS’’) market data feed. Specifically, 

the Exchange proposes removing 

messages related to administrative 

information and Liquidity Seeking 

Events (‘‘LSE’’) from ToM and the MEI 

Port connection, while also adding the 

information to the AIS data feed to the 

extent that it is not already included 

with AIS. 

ToM provides market participants 

with a direct data feed that includes the 

Exchange’s best bid and offer, with 

aggregate size, and last sale information, 

based on displayable order and quoting 

interest on the Exchange. The ToM data 

feed includes data that is identical to 

the data sent to the processor for the 

Options Price Regulatory Authority 

(‘‘OPRA’’). The ToM and OPRA data 

leave the MIAX system at the same time, 

as required under Section 5.2(c)(iii)(B) 

of the Limited Liability Company 

Agreement of the Options Price 

Reporting Authority LLC (the ‘‘OPRA 

Plan’’), which prohibits the 

dissemination of proprietary 

information on any more timely basis 

than the same information is furnished 

to the OPRA System for inclusion in 

OPRA’s consolidated dissemination of 

options information. In addition to 

MIAX’s best bid and offer, with 

aggregate size and last sale information, 

subscribers that currently subscribe to 

ToM also receive: opening imbalance 

condition information; opening routing 

information; Expanded 

Quote Range 4 information, as 

provided in MIAX Rule 503(f)(5); PostHalt Notification,5 as provided in MIAX 

Rule 504(d), and Liquidity Refresh,6

condition information, as provided in 

MIAX Rule 515(c)(2). This additional 

information (the ‘‘administrative 

information’’) is included in the ToM 

feed as secondary information. The 

administrative information is also 

currently available to non-Market 

Makers through the AIS data feed and 

MIAX Market Makers via connectivity 

with the MIAX Express Interface 

(‘‘MEI’’),7 for which they are assessed 

connectivity fees. 

The Exchange proposes to remove all 

the secondary administrative 

information including LSE related 

information from the ToM data feed and 

from the MEI Port connectivity service, 

with the exception of the Post-Halt 

Notification. The secondary 

administrative information and 


tkelley on DSK3SPTVN1PROD with NOTICES