question and answers about ETF's

1. How are actively managed ETFs likely to be structured, managed and operated?

Actively managed ETFs will likely be structured in a manner similar to existing index-based ETFs.

2. How will investors use, and benefit from, actively managed ETFs?

The growth over the last few years in index-based ETFs reflects investors' growing understanding and acceptance of the benefits and features that ETFs offer over traditional index-based open-end management investment companies, or mutual funds.¹ Since January, 1993 over 100 ETFs have been introduced that now have over $80 billion in assets. A research study conducted by Financial Research Corporation on "The Future of Exchange Traded Funds" found that the primary reasons for investor interest in ETFs are tax efficiency, trading flexibility, lower expense ratios, diversification and continuous pricing.² One need only compare the growth rate of index-based ETFs to that of traditional index mutual funds to demonstrate investor demand for the more flexible ETF product.

Actively managed ETFs could provide many of the same features and benefits as the existing ETFs. For example, actively managed ETFs that allow in-kind creation and redemption may experience increased tax efficiency over traditional actively managed mutual funds.

Actively managed ETFs will provide significant benefits to investors by expanding competition within the industry and providing additional choices for investors. They are likely to be used in a variety of ways, from investing 401k plans and wrap accounts, to trading vehicles for a particular universe of stocks or style of investing.

3. Would the exemptive relief that the Commission has granted to index-based ETFs be appropriate for actively managed ETFs?

Each application will have to be examined individually, based on its own unique circumstances. However, in general we would expect similar relief, although it is possible that additional relief may be necessary for some actively managed ETFs, as well as different representations and conditions in the exemptive application and the Commission's order for a particular fund's management and operations.

4. Are there any new regulatory concerns that might arise in connection with actively managed ETFs?

Possibly, although this is difficult to predict without actual experience. Each ETF exemptive application will have to be examined individually based on its own unique circumstances. We do not believe however, that there are any concerns or issues that cannot be dealt with by Commission's staff in the exemptive process, through prospectus disclosure and through Commission oversight.

Concept Release IV. Areas for Comment

A. Index-Based vs. Actively Managed ETFs

5. For purposes of the Concept Release, the Commission assumed that any ETF that would not seek to track the performance of a market index by either replicating or sampling the index securities in its portfolio would be an actively managed ETF. Is this an appropriate way to distinguish between index-based and actively managed ETFs?

The Commission has assumed that any ETF that does not seek to track the performance of a market index by either replicating or sampling the index securities in its portfolio would be actively managed. This would include leveraged and short index funds that seek to achieve a multiple (or the reverse) of the performance of a market index. We do not believe that the leveraged and short index funds should be considered active. These funds operate in virtually the same manner as ordinary index funds. Rather, investment objective and strategy, the degree of adviser discretion and flexibility and perhaps the contents of the portfolio, are key in determining whether a fund is actively managed.

6. Are there any reasons to distinguish between different types of actively managed ETFs?

If so, we think these distinctions will be primarily with respect to disclosure, or from a sales and marketing perspective, as well as based on a fund's investment strategy and methodology. However, this will be consistent with the way different types of actively managed mutual funds and UITs are currently distinguished. Active management is a broad description. In many cases active management involves an advisor making constant discretionary decisions on the investment merits of a specific security, sector, country, currency etc. In other cases active management may be a "rules-based" or "top picks" investment process, with very little discretion. "Rules-based" means a defined set of guidelines for the inclusion and deletion of securities in a portfolio, consistently applied, and made publicly available. "Top picks" is used here to describe well-defined and publicized lists of securities published by securities firms, which form the basis for packaged or basket products. Some active ETFs that are "rules-based" or "top picks" portfolios may disclose portfolio composition files on a frequency that is consistent with index-based ETFs, and are likely to operate the same way. Creation and redemption features may vary; some actively managed ETFs may require cash creations and/or redemptions. As noted in the Concept Release, ETFs issue shares only in large aggregations or blocks, called "Creation Units". An investor may purchase a Creation Unit with a "Portfolio Deposit" equal in value to the aggregate NAV of the aggregate ETF shares in the Creation Unit. The Portfolio Deposit generally consists of a basket of securities that mirrors the composition of the ETF's portfolio, and usually also includes a small amount of cash to account for the difference between the value of the basket of securities and the NAV of the ETF shares. ETF shares are not redeemable from the ETF except in Creation Unit aggregations. An investor presents a Creation Unit to the ETF for redemption, and receives a "Redemption Basket". The Redemption Basket usually contains the same securities in the Portfolio Deposit, along with a small amount of cash. However, some actively managed ETFs could have different creation and redemption baskets, i.e. the composition of the Portfolio Deposit would differ from the Redemption Basket.

7. If there are different types of actively managed ETFs, are there any reasons to regulate the various types differently?

This question cannot be answered unless specific types of actively managed ETFs are modeled in terms of their operation and then compared. Generally, any such reasons should be allowed to emerge on a case-by-case basis through applications for exemption by specific funds.

Concept Release IV. Areas for Comment
B. Operational Issues Relating to Actively-Managed ETFs

8. Is it important that ETFs be designed to enable arbitrage and thereby minimize the probability that ETF shares will trade at a large premium or discount?

Yes. The ability to arbitrage and thereby limit premia/discounts in secondary market prices is a significant factor in the acceptance and usage of ETFs by investors. The ability to arbitrage enhances market liquidity, efficiency and price discovery and would be an important factor for all investors using actively managed ETFs. It is in the interest of an actively managed ETF sponsor to work to insure that its product is not susceptible to significant premia or discounts for any sustained period of time. However, what is an acceptable level of premium/discount must be judged in the context of the particular exemptive application and ETF.

An important element in achieving a successful product is the availability of and appropriate disclosure of current information as to per-share portfolio value of the ETF throughout the trading day. In order to provide information to the market, the Exchange disseminates every 15 seconds over Network B of the Consolidated Tape Association an "indicative portfolio value" reflecting the fluctuating intra-day value for each ETF listed on the Exchange. [In the case of the replicated UIT ETFs, this indicative portfolio value is based on the applicable index.] The indicative portfolio value is calculated by a securities market information provider, and disseminated on a per-share basis every 15 seconds during the regular Amex trading hours of 9:30 a.m. to 4:00 p.m. Eastern time. The equity securities included in the indicative portfolio value generally reflect the same market capitalization weighing as the Portfolio Deposit which is part of the Creation Unit. This information is very important to the market in terms of achieving efficient pricing, and arbitrage.

9. In considering whether to grant the exemptive relief necessary to permit actively managed ETFs, should we be concerned about whether their shares will trade at a significant premium or discount?

Yes. However, actively managed ETFs, like index-based ETFs, should not experience significant "sustained" premia/discounts due to the open-end structure which allows shares outstanding to increase and decrease upon demand, and due to the availability of current market information such as indicative portfolio value throughout the trading day. The iShares MSCI ETFs (formerly known as WEBS) provide the best evidence in assessing the potential for significant and sustained premia/discounts in actively managed ETFs. These products, unlike SPDRs, MidCap SPDRs, DIAMONDS, and QQQs, are optimized index portfolios investing in foreign markets which are often closed while the ETF trades in the U.S. In the fall of 1997, after the start of the Thai currency crisis, the WEBS Hong Kong ETF experienced a large increase in the number of buy orders; this, combined with the underlying market being closed and uncertainty as to the levels the Hong Kong market would open caused the WEBS Hong Kong ETF to experience a premium greater than 20% to the last NAV. However, once the underlying market reopened and purchaser of Creation Units could be initiated, the WEBS Hong Kong ETF opened the next day with a reversal of such premium.

We note that if certain actively managed ETFs were to trade at a significant sustained discount they likely would not survive due to their open-end nature, because investors would buy the ETF shares at far less than NAV and redeem Creation Units, obtaining NAV and causing the ETF to shrink below an economic level for its sponsor.