January 29, 2019
- Many expect the SEC to soon approve newer versions of exemptive relief for the next generation of actively managed ETFs, which differ in how they keep the ETF’s strategy secret, how they support the arbitrage process and potential intellectual property (IP) protection.
- Five applicants have received and responded to SEC comments.
- Potential sponsors of this next generation of ETFs should understand these different models and related IP implications to decide what path they want to follow to be able to offer these ETFs.
Many believe the SEC is poised to allow for the first time the next generation of actively managed ETFs (Next Gen ETFs), which differ from traditional ETFs in that they differ in how they keep the ETF’s strategy secret, how they support the arbitrage process and potential intellectual property (IP) protection, as discussed further below. If the SEC opens the floodgates, the impact on the ETF industry and the asset management space in general will be seismic because of the pent-up demand to offer existing actively managed investment strategies in an ETF wrapper, as evidenced by the dramatic current imbalance between actively managed ETFs (approximately $45.8 billion in AUM) and index ETFs (approximately $3.36 trillion in AUM). A more normal equilibrium between the actively managed and index worlds may in large part be a zero-sum game, with accelerated outflows from mutual funds to ETFs.
Investment advisers should prepare for the advent of Next Gen ETFs by:
- studying, among other things, publicly available SEC exemptive applications and patents of the expected first Next Gen ETFs;
- exploring the possibility of developing their own Next Gen ETF methodologies;
- considering licensing Next Gen ETF methodology as a quicker route to launch such ETFs;
- preparing an application to be filed with the SEC for exemptive relief to launch their own Next Gen ETFs; and
- evaluating how offering Next Gen ETFs that largely clone their actively managed mutual funds will impact their business.
This edition of ETF Reg Insights describes Next Gen ETFs and their current regulatory status and details the five Next Gen ETFs expected to be approved simultaneously by the SEC (First Movers). It concludes with a discussion about what advisers should consider when making business decisions about how to potentially utilize these products.
Status of Next Gen ETFs
An ETF is an investment company registered with the SEC that publicly issues shares representing interests in a pool of securities. Unlike mutual funds, ETF shares trade on a primary market available only to “authorized participants” (APs) and a secondary market (Cboe, Nasdaq and NYSE) available to all investors through their broker-dealers. The price of the ETF shares at any point in time when a secondary market is open is determined by market forces. Thus, there is a bid and ask price throughout the trading day, just like the price of shares of Amazon, Apple and other operating companies. Each morning prior to the opening of the exchange, the ETF posts a list of all of its portfolio holdings (constituents) and its lead market maker sets its opening price.
After the exchange opens on a given day, a discrepancy almost immediately exists between the share price and the net asset value (NAV) per share of the ETF. Depending on the ETF’s size, typical volume of trading and other factors, this spread may be narrow or wide. The lynchpin of the ETF product is that APs (and market makers through APs) have various financial incentives to transact in the primary market to exploit this discrepancy. When the ETF share is trading at a premium of its NAV, an AP can acquire and deliver a basket of securities that replicate the ETF’s constituents, receive shares of the ETF and sell the shares for an aggregate price that exceeds the price it paid for the basket of the ETF’s portfolio constituents. This transaction is called a “creation.” Conversely, when the ETF share is trading at a discount to its NAV, an AP can buy shares of the ETF, redeem those shares from the ETF in exchange for a basket of the ETF’s portfolio constituents, and sell the portfolio constituents for an aggregate price that exceeds the price it paid for the ETF shares. This transaction is called a “redemption” or “redeem.”
As noted, the process can work only if the AP and other market participants know the makeup of the ETF’s portfolio, which the SEC under current ETF exemptive orders requires the ETF to post each day prior to the opening of trading on the market where it is listed. The great barrier obstructing rapid growth of actively managed ETFs has been the SEC’s requirement for such ETFs to disclose their investment portfolios on a daily basis, which potentially allows competitors to backtest their portfolios to determine their investment strategy (the “secret sauce”) or otherwise discern when they are entering or exiting existing positions, both of which create “front running” or “free riding” concerns.
Five financial firms or groups of firms continue attempts to overcome the actively managed ETF barrier by devising acceptable alternatives to the requirement that an actively managed ETF expose its portfolio each trading day. They have developed ETFs that, in lieu of daily exposing their portfolios and the exact security weights, make available enough information to theoretically allow arbitragers to exploit any discrepancy between the ETF’s NAV and share price without disclosing the ETF’s full portfolio to the public. The firms hope that in 2019 the SEC will finally approve the Next Gen ETF product, APs will embrace their models and assets will begin to flow into them.
Next Gen ETF Models
To our knowledge, five Next Gen ETF exemptive applications are pending with the SEC, which have been filed by Blue Tractor, Precidian, Fidelity, Natixis and T. Rowe Price. One of these firms (Precidian) filed a Next Gen ETF proposal with the SEC in 2013 that was withdrawn in 2014 following an SEC notice indicating its intent to deny the application and criticism of the proposed intraday disclosures intended to act as a substitute for daily portfolio holdings disclosure. To address these comments, all of the current pending applications include more refined supplementary forms of intraday disclosures to facilitate arbitrage activities. Variation exists between the Next Gen models in terms of the level of transparency of the actual securities that make up the portfolio composition file (PCF). Since the creation/redemption process can also be a form of information “leakage” about the Next Gen ETF’s portfolio to APs and other market participants, the basket of securities that a Next Gen ETF will accept or deliver in exchange for a creation unit, or the process for a creation or redemption, differs from that of traditional ETFs. The applications for some models assert claimed patent protection on certain aspects of these processes. These aspects of the five pending Next Gen ETF exemptive applications are summarized below.
Models Claiming Patent Protection
Blue Tractor ETF Trust and Blue Tractor Group
Daily disclosures. After the close of trading on day T, an ETF fund (or its custodian) will access a secure cloud software platform called the Blue Tractor Shielded Alpha℠ Service, which generates a portfolio (the Dynamic SSR℠ portfolio) that will be the in-kind creation basket for trading on day T+1. The actual portfolio is never disclosed on a daily basis, only the generated Dynamic SSR portfolio. As per current ETF industry practice, this basket will be published by the NSCC as the Next Gen ETF’s PCF and used by market makers and authorized participants on day T+1 for high-frequency intra-day pricing, hedging, to effect bona fide arbitrage and for in-kind creations and redemptions with the Next Gen ETF. The basket will hold 100% of the actual portfolio securities (and no others), but the portfolio weightings in the basket will differ from the actual portfolio weightings. Importantly, the basket will have a minimum 90% asset value overlap with the actual portfolio. Because the market will know 100% of the portfolio holdings (but not the actual weightings), the applicants in the Blue Tractor Application believe that the structure is more accurately characterized as a substantially transparent ETF and not a non-transparent ETF. At the close of each day’s trading a new basket is generated that will have randomly generated portfolio weightings that always differ from the actual portfolio; it is the daily change in basket weightings that fully obfuscates the Next Gen ETF’s alpha generation strategy
Creation/redemption process. Creations and redemptions will be effected directly by authorized participants with the Next Gen ETF through the in-kind transfer of securities in the Dynamic SSR portfolio. Because of the minimum 90% in asset value overlap between the Next Gen ETF portfolio and the Dynamic SSR portfolio, the Blue Tractor Application states that the in-kind exchange is anticipated to be relatively tax-efficient and low-cost. A cash amount may be required or paid in lieu of certain positions, according to the circumstances described in the Blue Tractor Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
Precidian ETF Trust, Precidian ETF Trust II and Precidian Funds LLC
Daily disclosures. The sponsor disseminates a verified intraday indicative value (VIIV) of the actual Next Gen ETF’s portfolio throughout the trading day. The VIIV will be calculated every second throughout the trading day and on a per-share basis based on the value of the actual securities in the fund’s portfolio, cash and any accrued interest and declared but unpaid dividends, minus accrued liabilities. Using a current VIIV along with existing fund disclosures, APs are expected to do a regression analysis and construct dynamic hedge portfolios to hold shares and arbitrage the difference in the market price/NAV of shares when the opportunity arises.
Creation/redemption process. This model takes an “AP representative structure” approach. Unlike traditional ETF APs that transact directly with the ETF through the distributor or transfer agent, APs for these Next Gen ETFs will need to transact through an “AP representative” that will be privy to the Next Gen ETF’s creation basket but will be contractually required to maintain the confidentiality of the basket’s contents. The AP representative will use a confidential brokerage account on behalf of each AP for this purpose. While creation and redemption transactions with the Next Gen ETF will generally be on an in-kind basis, from the AP’s perspective, because of the interposition of the AP representative, transactions will essentially be made on a cash basis. The AP representative will purchase securities in the basket (in the case of a creation) or liquidate securities transferred from the Next Gen ETF’s custodian (in the case of a redemption).
NYSE/Natixis Advisors, L.P. and Natixis ETF Trust II
Daily disclosures. A Next Gen ETF offered by Natixis would disclose a proxy portfolio (Proxy Portfolio) instead of its actual portfolio, which will be comprised of securities in the Next Gen ETF’s potential universe of portfolio securities and is designed to achieve an end-of-day tracking error of no more than 5% compared to the performance of the Next Gen ETF’s actual portfolio. The Proxy Portfolio will be constructed using the NYSE’s proprietary process that uses a factor analysis of a Next Gen ETF’s actual portfolio. The Proxy Portfolio is designed to be overinclusive and will contain more components than the Next Gen ETF’s actual portfolio. In addition, purchases and sales occurring in the Next Gen ETF’s actual portfolio will not be reflected in the Proxy Portfolio until after a 5- to 15-day lag, and the Proxy Portfolio’s aggregate value on any given trading day will equal the aggregate NAV of the Next Gen ETF’s actual portfolio. Each day before market open, a Next Gen ETF’s Proxy Portfolio will be disclosed on its website, along with the historical tracking error between the ETF’s last published NAV per share and the Proxy Portfolio’s value, on a per-share basis.
Creation/redemption process. Creations and redemptions will be effected primarily through the in-kind transfer of securities in the Proxy Portfolio. A cash amount may be required or paid in lieu of certain positions, according to the circumstances described in the Natixis Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
Models Without Claimed Patent Protection
Fidelity Beach Street Trust, Fidelity Management & Research Company, FMR Co., Inc. and Fidelity Distributors Corporation
Daily disclosures. This model takes a “closed-end structure” approach utilizing a tracking basket to disclose a representative portfolio that can be used to construct a reliable hedge against the securities in the Next Gen ETF’s portfolio (Tracking Basket). The Tracking Basket includes a Next Gen ETF’s most recently disclosed portfolio holdings and representative ETFs. The Fidelity Application states that ETFs included in the Tracking Basket will be limited to 50% of the Tracking Basket’s assets. Fidelity will use a proprietary mathematical process to minimize the deviation between the basket and the actual portfolio of the Next Gen ETF. The Tracking Basket will be reconstituted at least as often as a Next Gen ETF’s portfolio holdings are publicly disclosed but may be rebalanced more frequently at Fidelity’s discretion. Fidelity proposes to monitor the deviation between the Tracking Basket’s performance and the actual portfolio using a 5% threshold, which the Fidelity Application states “will be calculated as the annualized standard deviation of the daily difference between the actual NAV of the Fund and the calculated closing NAV of the Tracking Basket measured over a trailing 90 calendar days.” The indicative NAV of the Tracking Basket will be disseminated every 15 seconds throughout the trading day, and the Tracking Basket will be published daily on a fund’s website prior to commencement of trading.
Creation/redemption process. Creations and redemptions will be effected primarily through the in-kind transfer of securities in the Tracking Basket. A cash amount may be required or paid in lieu of certain positions according to the circumstances described in the Fidelity Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the creation basket exchanged for the creation unit).
T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc.
Daily disclosures. Similar to the Fidelity Application, under this model, a “hedge portfolio” will be disclosed daily for each Next Gen ETF (Hedge Portfolio). There will be an 80% overlap of the securities in the Hedge Portfolio and a Next Gen ETF. In addition, an indicative NAV based on each Next Gen ETF’s actual portfolio will be disclosed at 15-second intervals throughout the trading day. In addition to these disclosures, T. Rowe will provide daily information about the deviation between the Hedge Portfolio and a Next Gen ETF’s actual portfolio. T. Rowe would provide the deviation between the performance of the Next Gen ETF’s NAV and its Hedge Portfolio for the most recent rolling one-year period, which will be calculated using prices as of the end of each relevant trading day (Daily Deviation). T. Rowe would also provide metrics on annual “tracking error” (i.e., the standard deviation of the Daily Deviation between a Next Gen ETF’s NAV performance and that of its Hedge Portfolio) and the percentage of Daily Deviations that exceeded a certain number of basis points over the past year.
Creation/redemption process. Similar to the Fidelity Application, creations and redemptions will be effected primarily through the in-kind transfer of securities in the Hedge Portfolio. A cash amount may be required or paid in lieu of certain positions according to the circumstances described in the T. Rowe Application (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).
To License or Not to License
If an adviser decides that a Next Gen ETF should be in its product lineup, a key follow-on decision will be whether to obtain a license to use the methodology from one of the Next Gen ETF First Movers (assuming one of the sponsors noted above is making some or all of its methodology described in the application available to licensees) or to devise its own methodology that is acceptable to the AP community and meets the requirements of the SEC staff. Potential sponsors should note, however, that novel applications take time to receive SEC approval. Most Next Gen ETF First Movers’ applications have been pending for over two years.
The obvious advantage of licensing the methodology from a First Mover is speed to market. First, it takes time and expense to develop a methodology that will be successful. Second, licensing avoids the risk that a First Mover may claim the firm’s new methodology infringes on its proprietary methodology. Licensing should also shorten the time it takes for an adviser to obtain a Next Gen ETF exemptive order, since the SEC staff will have already signed off on the methodology, which has been the key sticking point so far with the First Movers’ applications. Furthermore, the First Movers have a head start in interacting with APs and market makers, so they are willing to facilitate creations and redemptions utilizing the methodologies.
An obvious potential disadvantage is having to pay a licensing fee. (To the extent the fee is similar to a fee to license an index, it may be neutral from a financial standpoint if a sponsor is contemplating a strategy that could be managed actively or passively through a custom index.) There is also the risk of selecting one First Mover’s methodology when another would have been superior. Licensees should be prepared for license terms that impose obligations, conditions and restrictions, for example, reporting obligations and conditions for sharing information or technology. A license agreement establishes a contractual relationship and can risk later disputes for an alleged breach.
An adviser that licenses Next Gen ETF methodology should pay particularly close attention to the licensing agreement to avoid pitfalls that could have lasting ill effects. Key provisions and possible negotiating points to be aware of for any licensing agreement are listed below, but vary depending on the counterparty and the relationship that is contemplated.
- Term and termination: An adviser may not want to be locked into a methodology too long, but also may not want to give up pricing certainty before a Next Gen ETF hits its break-even point. An adviser should have the right to terminate if regulatory authorities later reject the methodology or if the provider fails to enforce its rights against the adviser’s competitors.
- Patent definition: An adviser must guard against definitions of patent and other IP rights (e.g., “know-how,” “licensed IP”) that are overly broad and potentially preclude contractually the adviser’s attempt to develop its own methodology.
- Nature of patent rights: Where a royalty rate is based in part on patent rights, an adviser should take reasonable steps to ensure that the methodology of interest is actually covered by the patent’s claims and unobvious over prior methodologies.
- Non-compete: An adviser should have the freedom to launch ETFs using its own methodology.
- Infringements: An adviser should have some role or at least rights to information regarding infringement lawsuits that threaten the adviser’s ability to use the methodology.
- Confidentiality: The adviser should have the right to sufficient information about the methodology to facilitate its management of the portfolio securities of the ETF and to be able to share such information with APs that facilitate the creation and redemptions of ETF baskets.
- Indemnification: The indemnity clauses are especially important, including how they relate to infringement actions.
- Rate: An established licensor may have standard, non-negotiable royalty rates. But an adviser should try to negotiate reduced rates for a new methodology. A “most favored nation” clause can be helpful in requiring a licensor to offer the adviser a lower rate if later offered to another licensee.
Developing Proprietary Methodology
Many advisers undoubtedly will develop their own methodologies, primarily to avoid paying a licensing fee to a third party. It is quite possible that they will come up with superior methodologies, which they may potentially want to license.
Going this route likely will require scale, especially to entice APs and other market makers to familiarize themselves with still another Next Gen ETF methodology. Scale may also be necessary because of the expense of not only developing the methodology, but also protecting its intellectual property through patents and possibly defending against an infringement case brought by a Next Gen ETF First Mover. One might expect advisers of large mutual fund complexes who have been on the sidelines or barely on the ETF playing field to be the most likely to develop their own proprietary methodologies. Advisers should keep in mind that meaningful patent protection for many business methodologies has been especially difficult to obtain and enforce since a landmark 2014 decision by the U.S. Supreme Court. Alice Corp. v. CLS Bank International, 573 U.S. 208, 134 S. Ct. 2347. In some cases, copyright and trade secret protection for the underlying software will help protect exclusivity.
Therefore, advisers developing their own proprietary Next Gen ETF methodologies should:
- study the Next Gen ETF First Movers’ patents and develop methodologies that steer clear of key attributes of existing methodologies;
- consider the patentability of their methodologies and apply for patent protection before the methodologies are commercially used or offered for license or publicly disclosed;
- consider copyright and trade secret protection and take the necessary steps to protect and enforce those rights; and
- allow ample time for the SEC to review their exemptive applications setting forth their methodologies and for APs and market makers to understand them.
Other Noteworthy Aspects of the Models
Limitations on Next Gen ETF Portfolio Securities
The current iterations of the Next Gen ETF applications each represent that the Next Gen ETFs will generally be limited to investments in exchange-traded equity securities, depositary receipts and certain other types of exchange-traded instruments (e.g., other ETFs, exchange-traded notes and index futures). Therefore, the first iteration of these products would be limited to equity Next Gen ETFs. In the future, as market participants (particularly APs) gain more trading experience with the various models, the SEC may permit Next Gen ETFs to invest in a broader universe of investments.
Regulation Fair Disclosure
Each application includes compliance with Regulation Fair Disclosure (Reg. FD) as a condition. Currently, ETFs and mutual funds are required to comply with disclosure requirements regarding “selective disclosure of portfolio holdings,” which generally requires them to adopt policies and procedures regarding disclosure of nonpublic information about securities in the fund’s portfolio and disclosure in their registration statements of the parties that have access to such disclosure. Reg. FD generally requires contemporaneous disclosure of material nonpublic information to certain specified persons also be made to the public, unless the recipient is contractually required to keep the information confidential.
Because Next Gen ETFs have the potential to be game-changers in the ETF industry, now is the time for advisers of mutual funds and index ETFs to begin understanding these products and deciding whether Next Gen ETFs should be in their product line. Waiting too long may prove costly because assets can shift quickly, especially to superior products like ETFs. Of course, patience may also be necessary since the SEC to date has not completely signed off on Next Gen ETFs and governmental and regulatory delays may continue to be in vogue in Washington, D.C. in 2019.
FOR MORE INFORMATION
For more information, please contact:
Christopher D. Carlson
Clifton E. McCann
 See Proposed Rule: Exchange-Traded Funds, SEC Rel. No. IC-33140 (June 28, 2018) at nn. 3 and 63 and accompanying text (noting that all ETFs registered with the SEC have $3.4 trillion in assets and there are over 200 actively managed ETFs with approximately $45.8 billion in assets as of the end of 2017, based on estimates from MIDAS, Bloomberg and Morningstar Direct).
 Precidian ETFs Trust, et al., Notice of Application (SEC Rel. No. IC-31300) (Oct. 21, 2014).
 Precidian Application at 22-23.