BY BIBB STRENCH AND RICHARD KEARY
October 3, 2017
Exchange-traded fund (ETF) boards soon will be knee deep in reports and presentations designed to facilitate their compliance with the SEC’s new liquidity rule. Rule 22e-4 under the Investment Company Act of 1940 will require ETFs (and mutual funds) by December 1, 2018 (June 1, 2019 for ETF complexes with less than $1 billion of assets) to have a liquidity risk management (LRM) program and imposes comprehensive new portfolio liquidity responsibilities on boards when overseeing the LRM programs. We caution that ETFs boards must not take a “check-the-box” mentality when carrying out this function. Rather boards should push beyond factors identified in Rule 22e-4 and statistical vendor-provided data to consider more nuanced factors and circumstances that ultimately are the best indicators of the risk that a given ETF will fail to satisfy a redemption order.
Many of Rule 22e-4’s requirements are similar in terms of structure to other SEC rules applicable to investment company boards, including approving the LRM program, designating a person to administer the LRM program and reviewing reports on the LRM program. Rule 22e-4 has other important requirements that a board will oversee such as a 15% cap on illiquid securities, classifying the portfolio of an ETF that does not qualify as an “In-Kind ETF” into four categories if that ETF includes a non-de minimis amount of cash in in-kind redemptions and regular and special SEC reporting requirements. Our focus is the Rule’s core requirement that the LRM program be reasonably designed to assess and manage each ETF’s liquidity risk while taking into account the five factors set forth in the Rule.
Rule 22e-4’s Five Factors
The five Rule 22e-4 factors with our commentary are discussed below.
1. Each ETF’s investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions, including the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers, and the use of borrowings for investment purposes and derivatives.
This factor directs the board to look through the ETF to its underlying portfolio holdings by requiring an analysis of the ETF’s portfolio securities in normal and stressed conditions. Boards should request data such as bid-ask spreads, volatility of trading prices, average daily trading volume of the portfolio securities and maturity dates of fixed-income securities held by the ETF during normal and stressed market scenarios. The investment strategy and nature of the ETF (and its holdings) will dictate how deep of an analysis will be warranted. For example, a small ETF in terms of assets under management with large cap strategy likely will have highly liquid portfolio securities and require less nuanced scrutiny. At the other extreme, esoteric ETFs require a more in-depth analysis of the ETF’s underlying portfolio holdings. This may necessitate the consideration of a host of other factors such as who makes markets in the portfolio security, what types of institutions own the portfolio security and what is the volatility of the portfolio security. Obviously, the board will have to rely on summaries of the data and analysis prepared by the ETF’s adviser or vendors or risk being paralyzed with too much information.
Factor 1 also mentions an ETF’s use of borrowings for investment purposes and derivatives. Leveraged ETFs typically invest a sizable amount of their assets (e.g., 80 percent or more) in the securities of the target index or treasuries with the remaining assets invested in cash or cash equivalents, against which the ETFs enter into derivatives transactions (typically futures and swaps) to obtain the remaining targeted exposure. The Boards of these types of ETFs will have to monitor the liquidity of these arrangements, which, among other things, will require the adviser to provide them with information and analysis of the counterparties in such arrangements and the liquidity and characteristics of the securities held in segregated accounts to cover or that are pledged to satisfy margin and regulatory requirements.
2. Short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions.
Cash flow projections are far less relevant to ETFs than mutual funds because ETFs typically receive securities and only small amounts of cash when investors purchase their shares. In fact, many ETFs, especially small- to mid-sized ETFs experience multiple days in a row when no cash is arriving or departing from the ETF as a result of no creates and redeems, respectively. On the other hand, cash flow projections for fixed-income ETFs may be highly relevant, especially with respect to high yield bonds that trade in less liquid markets and highly stressed fixed-income market scenarios.
3. Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.
This factor is more applicable to mutual funds than ETFs. Mutual funds, unlike ETFs, typically do not have redemption in kind mechanisms in place and thus are highly dependable on cash on hand or borrowing facilities to meet daily redemption requests. ETFs operate entirely differently, making episodic redemptions in kind to APs. Other than a de minimis amount of cash to facilitate irregular baskets and rebalancing by index ETFs, cash on hand only serves to be a drag on the ETF’s performance and, for index ETFs, causes them to deviate further from the performance of the index they are tracking
4. The relationship between the ETF’s portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade, including, the efficiency of the arbitrage function and the level of active participation by market participants (including authorized participants).
Factor 4 provides boards with possible symptoms of illiquidity of an ETF rather than its actual liquidity. As spreads in an ETF’s offering and bid price and offering price and net asset value per share increase beyond a generally acceptable level or peer ETFs, it may suggest potential issues including liquidity issues. Wider spreads will trigger the Board’s need for different inputs and types of data and analysis of that data to better pinpoint the liquidity of an ETF.
The fact that a given ETF has relatively few APs should cause a board to pause to ask more questions about the APs that interface with the ETF. APs do not receive compensation from an ETF or its sponsor and have no legal obligation to create or redeem the ETF’s shares, obviously making ETF issuers more dependent upon surviving APs for liquidity when other APs find it no longer profitable to transact business with them. On the other hand, an ETF may have an excellent relationship with one or two APs or the APs that specialize and hold inventories of the type of securities that the ETF invests in, making the number of the ETF’s APs less relevant.
5. The effect of the composition of baskets on the overall liquidity of the ETF’s portfolio.
While Factor 5 is worded broadly, one way in which this factor may be considered by the board is looking at the ETF’s “implied liquidity.” ETF implied liquidity gets at a key concept of Rule 22e-4: the extent that an ETF’s portfolio security can be converted to cash without significantly changing the market value of that portfolio security. Implied liquidity calculations require a comparison to the total number of shares of a given portfolio security with the average trading volume of that security. For example, some believe that a position in a given security may raise liquidity concerns if it is greater than 25% of the 30-day average volume of the security. For many ETF boards, it may be prudent for them to understand what an acceptable implied liquidity for a given ETF and the implied liquidity of that ETF at a given time.
Implied liquidity is a good measure assuming “normal” market conditions. The SEC in the releases proposing and adopting Rule 22e-4 also want consideration during “foreseeable stressed conditions.” That phasing leaves open a lot of interpretation and most problems of illiquid securities almost always arise during periods of market stress. Asking the lead market maker and other APs on how they handle various types of securities during different market conditions can go a long way in properly analyzing an ETF’s portfolio securities. Thus, ETF boards likely will have to be mindful of and consider subjective factors discussed in the next section that are not expressly stated in Rule 22e-4 and its proposing and adopting releases.
Beyond the Five Factors
Depending on the nature of the ETFs in a given ETF complex, it may be necessary for ETF boards to demand information and analysis on one or more factors discussed below.
Setting aside much of the numeric analysis noted above (including implied liquidity), an ETF board will want to consider and receive input from the ETF’s liquidity provider. For example, the Board may want to review information about actual large trades made by the ETF that theoretically should raise liquidity concerns, especially when such large trades were executed without adversely impacting the Fund. For example, an ETF trades a 100,000 share block that is more than three times the average daily volume of the ETF. There is no impact because the ETF adviser that initiated this trade was able to work with an ETF liquidity provider that had the ability to access its own inventory of that security or other sources of liquidity to facilitate the block trade. Also, the board may want to know how particular liquidity providers acted during market events such as the 2010 and 2015 “Flash Crashes” and Brexit. Did they trade or temporarily disappear?
One issue that comes to light every time we see market disruptions is the challenge of market structure in times of stress. There are instances, like the flash crashes, where the ETF structure is unfairly blamed for fueling the crashes. ETFs trade on exchanges under the same rules as corporate securities, yet they are completely different products. ETF boards should understand the challenges of market structure on less liquid stocks, as well as each new and improved circuit breakers and other trading reforms designed to return markets back to normal. Since these factors will not appear in the metrics that the Boards will be provided by third-party vendors, the ETF board will need the adviser to set the stage for a robust discussion around market structure for illiquid securities.
Portfolio Manager/Traders Input
The input, including subjective input, from the ETF’s portfolio manager and/or trading desk is vital to the board’s understanding of a given ETF’s liquidity. In many cases, the portfolio manager will have the best information about each portfolio security, including who else owns its, inflow and outflow patterns and the brokers that make markets in it. For example, it may be relevant that the owners of a small cap ETF largest portfolio positions are mutual funds and other ETFs, which are expected to act the same way in stressful markets.
The shareholders of an ETF should be considered when examining the liquidity of that ETF. In many cases, ETF providers do not know who owns their shares since shareholder information is held at unaffiliated broker-dealers that interface with the ETF’s authorized participants through a process administered by the National Securities Clearing Corporation (NSCC). However, ETF providers directly or through their APs often can identify the large shareholders of their ETFs through SEC reporting and other means. The type of shareholder, whether the ETF’s outstanding shares are concentrated in a small number of shareholders and similar factors are all important to a liquidity analysis. For example, it would be highly relevant to a liquidity analysis that a hedge fund with a market timing strategy is the ETF’s largest shareholder.
Educating the independent directors of the ETF boards on the proposed LRM Program and more generally liquidity measurements and how they relate to the specific ETFs is paramount to assisting in compliance with Rule 22e-3. One suggestion would be to ask internal experts at the adviser’s firm in conjunction with the lead market maker and/or other APs to present to the board how they measure liquidity. Some of the metrics will be different than the SEC requirements and thus an important part of education of the independent directors of the Board. Since the learning curve is steep and there are complexities around each corner of the ascent, it would be prudent for boards to begin the journey sooner rather than later.