[Federal Register Volume 66, Number 221 (Thursday, November 15, 2001)]
[Proposed Rules]
[Pages 57614-57624]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-28572]



[[Page 57613]]

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Part VI





Securities and Exchange Commission





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17 CFR Part 270



Actively Managed Exchange-Traded Funds; Proposed Rule

  Federal Register / Vol. 66, No. 221 / Thursday, November 15, 2001 / 
Proposed Rules  

[[Page 57614]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-25258; File No. S7-20-01]
RIN 3235-AI35


Actively Managed Exchange-Traded Funds

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Concept release; request for comments.

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SUMMARY: The Commission is seeking comment on various issues relating 
to actively managed exchange-traded funds (``ETFs''). All existing ETFs 
are based on various equity market indices. An actively managed ETF 
would not track an index. This type of ETF currently does not exist, 
and the Commission is interested in public comments on this concept to 
help inform the Commission's consideration of any proposals for 
actively managed ETFs.

DATES: Comments must be submitted on or before January 14, 2002.

ADDRESSES: Persons wishing to submit written comments should send three 
copies of the comment letter to Jonathan G. Katz, Secretary, 
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following E-mail address: 
[email protected]. All comment letters should refer to File No. S7-
20-01, and comments submitted by E-mail should include this file number 
in the subject line. Comment letters received will be available for 
public inspection and copying in the Commission's Public Reference 
Room, 450 Fifth Street, NW, Washington, DC 20549. Electronically 
submitted comment letters also will be posted on the Commission's 
Internet web site (http://www.sec.gov). The Commission does not edit 
personal identifying information, such as names or E-mail addresses, 
from electronic submissions. Submit only the information you wish to 
make publicly available.

FOR FURTHER INFORMATION CONTACT: Michael W. Mundt, Senior Special 
Counsel, or Nadya B. Roytblat, Assistant Director, at (202) 942-0564 
(Office of Investment Company Regulation, Division of Investment 
Management, Commission, 450 Fifth Street, NW., Washington, DC 20549-
0506).

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. The Popularity of ETFs
    B. What Are ETFs?
    C. The Purpose of the Concept Release
II. Background
    A. The Development of Existing ETFs
    1. ETFs Organized as UITs
    2. ETFs Organized as Open-End Funds
    B. How Existing ETFs Operate
    1. Secondary Market Trading
    2. Arbitrage Opportunities
    C. Reported Uses and Benefits of Existing ETFs
    1. ETFs as a Tool for Individual Investors
    2. The Uses of ETFs for Institutional Investors
    3. The Efficiency of ETFs
III. The Concept of an Actively Managed ETF
IV. Areas for Comment
    A. Index-Based ETFs vs. Actively Managed ETFs
    B. Operational Issues Relating to Actively Managed ETFs
    1. Transparency of an ETF's Portfolio
    2. Liquidity of Securities in an ETF's Portfolio
    3. Other Operational Issues
    C. Uses, Benefits and Risks of Actively Managed ETFs
    D. Exemptive Relief from the Investment Company Act for Actively 
Managed ETFs
    1. Relief for ETFs to Redeem Shares in Large Aggregations Only
    2. Relief for ETF Shares to Trade at Negotiated Prices
    3. Relief for In-Kind Transactions between an ETF and Certain 
Affiliates
    4. Relief for Certain ETFs to Redeem Shares in More Than Seven 
Days
    E. Potential New Regulatory Issues
    1. Potential Discrimination Among Shareholders
    2. Potential Conflicts of Interest for an ETF's Investment 
Adviser
    3. Prospectus Delivery in Connection with Secondary Market 
Purchases
    F. The Concept of an Actively Managed ETF as a Class of a Mutual 
Fund
    1. Multiple Class Open-End Funds
    2. An Index-Based ETF as a Class of an Existing Open-End Fund
    3. ETF Class of an Actively Managed Open-End Fund
V. Solicitation of Additional Comments

I. Introduction

A. The Popularity of ETFs

    The growing interest in exchange-traded funds (``ETFs'') is one of 
the notable developments in the area of investment management over the 
past few years. During the year 2000, the number of ETFs increased from 
30 to 80, and the amount of assets held by ETFs nearly doubled from $34 
billion to $66 billion.\1\ While the total amount of ETF assets at the 
end of 2000 was still relatively small when compared to the 
approximately $4 trillion of assets in equity open-end investment 
companies (``open-end funds'' or ``mutual funds''), ETF assets were 
much closer to the $89 billion of total assets invested in unit 
investment trusts (``UITs'') and the $135 billion of total assets 
invested in closed-end investment companies (``closed-end funds'').\2\ 
Moreover, during the first three quarters of 2001, net new investment 
in ETFs amounted to approximately $24 billion, as compared to 
approximately $13 billion for equity mutual funds.\3\ By the end of 
September 2001, shareholders had invested more than $64 billion in a 
total of 92 ETFs.\4\ Trading in ETF shares reportedly has accounted for 
as much as two-thirds of the daily volume on the American Stock 
Exchange (``AMEX'').\5\
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    \1\ Investment Company Institute (``ICI''), Exchange-Traded 
Funds Statistical Collection, Feb. 8, 2001. Except for this ICI 
release, the ICI statistical releases cited in this concept release 
may be found under ``Current Statistical Releases'' or ``Additional 
Statistical Releases'' at http://www.ici.org/facts_figures/.
    \2\ ICI, Trends in Mutual Fund Investing July 2001, Aug. 30, 
2001 (for year-end 2000 mutual fund assets); Unit Investment Trust 
Data July 2001, Aug. 21, 2001 (for year-end 2000 UIT assets); 
Closed-End Fund Assets, 1990-2000 (for year-end 2000 closed-end fund 
assets).
    \3\ ICI, Exchange-Traded Fund Assets, Oct. 19, 2001 (for third 
quarter 2001 net investment in ETFs); ICI, Exchange-Traded Fund 
Assets June 2001, July 24, 2001 (for second quarter 2001 net 
investment in ETFs); ICI, Exchange-Traded Fund Assets March 2001, 
Apr. 26, 2001 (for first quarter 2001 net investment in ETFs); and 
ICI, Trends in Mutual Fund Investing September 2001, Oct. 29, 2001 
(for year-to-date net investment in mutual funds through third 
quarter 2001).
    \4\ ICI, Exchange-Traded Fund Assets, Oct. 19, 2001.
    \5\ Aaron Lucchetti and Ken Brown, Spiders and WEBS: Amex Is 
Back, Thanks To a Tradable Variety of Index Mutual Funds, Wall St. 
J., Feb. 22, 2000, at A1.
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B. What Are ETFs?

    ETFs are investment companies that are registered under the 
Investment Company Act of 1940 (``Act'') as open-end funds or UITs.\6\ 
Unlike typical open-end funds or UITs, ETFs do not sell or redeem their 
individual shares (``ETF shares'') at net asset value (``NAV'').\7\ 
Instead, ETFs sell and redeem ETF shares at NAV only in large blocks 
(such as 50,000 ETF shares). In addition, national securities exchanges 
list ETF shares for trading, which allows investors to purchase and 
sell individual ETF shares among themselves at market prices throughout 
the day. ETFs therefore possess

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characteristics of traditional open-end funds and UITs, which issue 
redeemable shares, and of closed-end funds, which generally issue 
shares that trade at negotiated prices on national securities exchanges 
and are not redeemable.\8\ A fundamental characteristic of all existing 
ETFs traded in the United States is that they are based on specific 
domestic and foreign market indices. An ``index-based ETF'' seeks to 
track the performance of an index by holding in its portfolio either 
the contents of the index or a representative sample of the securities 
in the index.
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    \6\ Section 5(a)(1) of the Act defines an open-end fund as an 
investment company that is a management company which offers or has 
outstanding any redeemable security of which it is the issuer. 15 
U.S.C. 80a-5(a)(1). Section 4(2) of the Act defines a UIT as an 
investment company that is organized under a trust indenture or 
similar instrument, that does not have a board of directors, and 
that issues only redeemable securities, each of which represents an 
undivided interest in a unit of specified securities. 15 U.S.C. 80a-
4(2).
    \7\ The NAV of a share of an investment company is equal to the 
value of the investment company's total assets, minus liabilities, 
divided by the number of outstanding shares.
    \8\ Section 5(a)(2) of the Act defines a closed-end fund as any 
management company other than an open-end company. 15 U.S.C. 80a-
5(a)(2)
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C. The Purpose of the Concept Release

    Recently, the concept of an ``actively managed ETF'' has attracted 
significant attention, even though many of the details regarding the 
potential operations of actively managed ETFs are apparently still in 
development.\9\ Unlike an index-based ETF, an actively managed ETF 
would not seek to track the return of a particular index by replicating 
or sampling index securities. Instead, an actively managed ETF's 
investment adviser could select securities consistent with the ETF's 
investment objectives and policies without reference to the composition 
of an index.
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    \9\ See, e.g., Anthony Ragozino and Charlie J. Gambino, 
Actively-Managed Exchange Traded Funds: Coming Soon to a Market Near 
You?, 8 Investment Lawyer, No. 5, May 2001, at 3 (``market 
professionals on Wall Street [are] scrambling to make [actively 
managed ETFs] available in the United States''); Dan Weil, Exchange-
traded Funds Boosts AMEX Growth, The Palm Beach Post, Mar. 9, 2001, 
at 2D (reporting that AMEX president says AMEX will probably begin 
trading actively managed ETFs within 12 to 18 months); Yuka Hayashi, 
New Generation of ETFs on Horizon, Wall St. J. Europe, Sept. 26, 
2000, at 16 (reporting that fund companies are ``pouring money into 
development'' of actively managed ETFs); Aaron Lucchetti, Firms May 
Explore Funds that Trade on Stock Markets, Wall St. J., May 16, 
2000, at C21 (reporting that AMEX official says about six mutual-
fund companies are interested in launching actively managed ETFs).
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    Because of their unique operations, index-based ETFs first must 
apply to the Commission to obtain exemptive relief from certain 
provisions of the Act. For example, exemptive relief is necessary for 
index-based ETFs to redeem ETF shares only in large aggregations and 
for ETF shares to trade at negotiated prices in the secondary market. 
An actively managed ETF also would be required to obtain exemptive 
relief from the Act.
    Before we can grant the exemptions necessary to permit the 
introduction of actively managed ETFs, we must conclude that the 
exemptions are in the public interest and consistent with the 
protection of investors and the purposes of the Act.\10\ As part of 
this process, we are issuing this release to seek comment from the 
public regarding the concept of actively managed ETFs. We expect that 
this concept release will generate comments and ideas from a wide range 
of parties, including individual and institutional investors, 
shareholder organizations, financial planners, investment advisers, 
fund organizations, market makers, arbitrageurs, ETF sponsors, and 
national securities exchanges. Our goal is to gain a better 
understanding of the various perspectives on the concept of actively 
managed ETFs. We then will be able to evaluate better any proposals for 
these types of products as they are presented to us through the 
exemptive process on a case-by-case basis.
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    \10\ 15 U.S.C. 80a-6(c).
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II. Background

A. The Development of Existing ETFs

1. ETFs Organized as UITs
    In January 1993, a subsidiary of the AMEX introduced the first ETF 
``the SPDR Trust. The SPDR Trust, which issues ETF shares referred to 
as SPDRs (pronounced ``spiders''), is a UIT that tracks the Standard & 
Poor's 500 Composite Stock Price Index (``S&P 500 Index'') by holding 
substantially all of the securities in the S&P 500 Index in 
substantially the same weightings as in the S&P 500 Index. The trustee 
adjusts the portfolio of the SPDR Trust only to reflect changes in the 
composition of the S&P 500 Index.\11\
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    \11\ Because the structure of a UIT does not include the means 
of providing management, the UIT portfolio is relatively fixed, and 
elimination and substitution of securities only takes place under 
unusual circumstances. However, a UIT that tracks an index (like the 
SPDR Trust) may make adjustments to its portfolio to ensure that the 
portfolio continues to replicate the index.
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    In order to offer SPDRs, the SPDR Trust obtained exemptions from 
various provisions of the Act.\12\ Among other things, the exemptions 
allow the SPDR Trust to redeem SPDRs in large aggregations only, SPDRs 
to trade at negotiated prices in the secondary market, dealers to sell 
SPDRs to purchasers in the secondary market unaccompanied by a 
prospectus (when prospectus delivery is not required by the Securities 
Act of 1933 (``Securities Act'')), and certain affiliated persons of 
the SPDR Trust to deposit securities into, and receive securities from, 
the SPDR Trust in connection with the purchase and redemption of large 
aggregations of SPDRs. Since the introduction of SPDRs, ETF sponsors 
have launched three additional ETFs organized as UITs. The MID CAP SPDR 
Trust tracks the Standard & Poor's (``S&P'') MidCap 400 Index; the 
Diamonds Trust (which issues units known as ``Diamonds'') tracks the 
Dow Jones Industrial Average; and the Nasdaq-100 Trust (which issues 
units known as ``Cubes'') tracks the Nasdaq-100 Index. Each of these 
ETFs obtained exemptive relief similar to the relief granted to the 
SPDR Trust.
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    \12\ SPDR Trust, Series 1, Investment Company Act Rel. Nos. 
18959 (Sept. 17, 1992) (notice) and 19055 (Oct. 26, 1992) (order) 
(``SPDR Order'').
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2. ETFs Organized as Open-End Funds
    In March 1996, ETF sponsors introduced the first two ETFs organized 
as open-end funds. The CountryBaskets Index Fund, Inc., advised by 
Deutsche Morgan Grenfell/C. J. Lawrence Inc., consisted of different 
portfolios (``series'') that tracked various country indices of the 
Financial Times/S&P Actuaries World Indices.\13\ The Foreign Fund, 
Inc., advised by BZW Barclays Global Fund Advisers (``Barclays''), 
offers series that track various Morgan Stanley Capital International 
(``MSCI'') country indices.\14\ These ETFs obtained exemptions from 
various provisions of the Act that were generally analogous to the 
exemptions obtained by the ETFs organized as UITs.\15\
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    \13\ The CountryBaskets Index Fund, Inc. ceased operations in 
March 1997 and deregistered as an investment company in 1998.
    \14\ The shares issued by The Foreign Fund were known as ``World 
Equity Benchmark Shares'' or ``WEBs.'' The ETF recently was renamed 
iShares Inc., and the shares are now known as ``iShares.''
    \15\ The CountryBaskets Index Fund, Inc., Investment Company Act 
Rel. Nos. 21736 (Feb. 6, 1996) (notice) and 21802 (Mar. 5, 1996) 
(order); The Foreign Fund, Inc., Investment Company Act Rel. Nos. 
21737 (Feb. 6, 1996) (notice) and 21803 (Mar. 5, 1996) (order).
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    Many ETFs organized as open-end funds replicate the holdings of 
their corresponding indices to track the performance of the indices. 
However, because ETFs organized as open-end funds employ investment 
advisers, some of these ETFs instead may use ``sampling strategies'' to 
track the performance of an index. Using a sampling strategy, an 
investment adviser can construct a portfolio that is a subset of the 
component securities in the corresponding index, rather than a 
replication of the index. The investment adviser also may acquire 
securities for the ETF portfolio that are not included in the 
corresponding index. While these ETFs still seek to track the 
performance of their respective indices, they have greater flexibility 
in accomplishing that goal. In addition, ETFs that are open-end funds 
are not prohibited from participating in securities lending

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programs or from using futures and options in achieving their 
investment objectives. The revenue generated by these activities may 
help the ETF to offset expenses that otherwise could cause the 
performance of the ETF to lag behind the performance of its index 
(because an index does not have any expenses). Eighty-eight of the 92 
ETFs in existence at the end of September 2001 were organized as open-
end funds.\16\
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    \16\ ETFs organized as open-end funds include the Select Sector 
SPDR Trust, consisting of series that track various S&P sector 
indices; iShares Inc. and iShares Trust, consisting of series that 
domestic and foreign equity indices compiled by S&P, Dow Jones & 
Company, Inc. (``Dow Jones''), Frank Russell & Co., and MSCI, and 
streetTRACKS Series Trust, consisting of series that track indices 
compiled by Dow Jones, Morgan Stanley Dean Witter, and FORTUNE.
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B. How Existing ETFs Operate

    Regardless of the organizational structure of an ETF, all existing 
ETFs operate in essentially the same manner. Unlike typical open-end 
funds or UITs, ETFs issue shares only in large aggregations or blocks 
(such as 50,000 ETF shares) called ``Creation Units.'' An investor, 
usually a brokerage house or large institutional investor, may purchase 
a Creation Unit with a ``Portfolio Deposit'' equal in value to the 
aggregate NAV of the ETF Shares in the Creation Unit. The investment 
adviser or sponsor of the ETF announces the contents of the Portfolio 
Deposit at the beginning of each business day. The Portfolio Deposit 
generally consists of a basket of securities that mirrors the 
composition of the ETF's portfolio. Because the purchase price of the 
Creation Unit must equal the NAV of the underlying ETF shares, the 
required Portfolio Deposit generally 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. The value of a Creation Unit 
typically exceeds several million dollars. After purchasing a Creation 
Unit, the investor may hold the ETF shares, or sell some or all of the 
ETF shares to investors in the secondary market.
1. Secondary Market Trading
    Like operating companies or closed-end funds, ETFs register offers 
and sales of shares under the Securities Act and list their ETF shares 
for trading on a national securities exchange under the Securities 
Exchange Act of 1934 (``Exchange Act''). As with any listed security, 
investors also may trade ETF shares in off-exchange transactions. In 
either case, ETF shares trade at negotiated prices. The development of 
the secondary market in ETF shares depends upon the activities of the 
exchange specialist assigned to make a market in the ETF shares and 
upon the willingness of Creation Unit purchasers to sell ETF shares in 
the secondary market.
    ETF shares purchased in the secondary market are not redeemable 
from the ETF except in Creation Unit aggregations. If an investor 
presents a Creation Unit to the ETF for redemption, the redeeming 
investor receives a ``Redemption Basket,'' the contents of which are 
identified by the ETF investment adviser or sponsor at the beginning of 
the day. The Redemption Basket (usually the same as the Portfolio 
Deposit) consists of securities and a small amount of cash. As with 
purchases from the ETF, redemptions from the ETF are priced at NAV 
(i.e., the value of the Redemption Basket is equal to the NAV of the 
ETF shares in the Creation Unit). An investor holding fewer ETF shares 
than the amount needed to constitute a Creation Unit may dispose of 
those ETF shares only by selling them in the secondary market. The 
investor receives market price for the ETF shares, which may be higher 
or lower than the NAV of the ETF shares. The investor also pays 
customary brokerage commissions on the sale.
2. Arbitrage Opportunities
    Because of arbitrage opportunities inherent in the ETF structure, 
ETF shares generally have not traded in the secondary market at a 
significant premium or discount in relation to NAV. If ETF shares begin 
to trade at a discount (i.e., a price less than NAV), arbitrageurs may 
purchase ETF shares in the secondary market and, after accumulating 
enough shares to equal a Creation Unit, redeem them from the ETF at 
NAV, and thereby acquire the more-valuable securities in the Redemption 
Basket. In purchasing the ETF shares, arbitrageurs create greater 
market demand for the shares, which may raise the market price to a 
level closer to NAV. If ETF shares trade at a premium (i.e., a price 
greater than NAV), arbitrageurs may purchase the securities in the 
Portfolio Deposit, use them to obtain the more-valuable Creation Units 
from the ETF and then sell the individual ETF shares in the secondary 
market to realize their profit. As the supply of individual ETF shares 
available in the secondary market increases, the price of the ETF 
shares may fall to levels closer to NAV. An exchange specialist 
designated to maintain a market in the ETF shares also works to provide 
appropriate amounts of shares in the secondary market in response to 
supply and demand.
    In addition, because the ETF investment adviser or sponsor 
announces the identities of the securities in the Portfolio Deposit and 
Redemption Basket each day, arbitrageurs also may decide to engage in 
arbitrage transactions based on their need for particular securities 
(for example, to replace borrowed securities that the arbitrageur 
previously sold ``short'') or on their own assessment of the relative 
value of the Portfolio Deposit or Redemption Basket in comparison to 
the price of the ETF shares. As an apparent result of this arbitrage 
discipline, ETF sponsors and market participants report that the 
average deviation between the daily closing price and the daily NAV of 
ETFs that track domestic indices is generally less than 2%.\17\ With 
respect to ETFs that track certain foreign indices, the deviations may 
be more significant.\18\
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    \17\ See, e.g, Second Amended and Restated Application of 
Barclays Global Fund Advisors, File No. 812-11600, filed May 11, 
2001 (``Barclays Application'') at 57-58 (stating that average 
deviations between the daily closing price and the daily NAV of ETF 
shares of ETFs tracking domestic indices range from a premium of 
.05% to a discount of .02%). Persons may obtain copies of 
applications cited in this concept release for a fee from the 
Commission's Public Reference Branch, 450 5th Street, NW., 
Washington, DC 20549-0102 (telephone 202/942-8090).
    See also John Spence, Salomon Releases ETF Premium/Discount 
Study, indexfunds.com, Oct. 23, 2000 (reporting that a Salomon Smith 
Barney study of the trading of ETF shares found that shares of ETFs 
tracking domestic indices had an average bid price that was a .17% 
discount to the ETFs' respective estimated intra-day NAVs, as 
recorded at random points during the trading days in September 
2000), at http://www.indexfunds.com/Pfarticles/20001023_SSMBstudy_iss_etf_JS.htm.
    \18\ See. e.g., Barclays Application at 36 (stating that the 
Malaysia (Free) WEBs Index Fund traded at wider spreads to NAV 
following the imposition of capital controls by the Malaysian 
government in 1998).
    See also Memorandum in Support of Hearing Request filed by Fund 
Democracy, LLC, and the Consumer Federation of America with respect 
to the Barclays Application (arguing that arbitrage opportunities do 
not ensure that the difference between the market price and NAV of 
ETF shares will remain narrow, and citing in particular the 
experience of ETFs tracking various foreign indices), available at 
http://www.funddemocracy.com/hearing_request_docs.htm.
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C. Reported Uses and Benefits of Existing ETFs

    In exemptive applications to permit the operations of ETFs, 
applicants have argued that ETFs provide investors and the markets with 
a number of benefits. First, applicants have argued that ETFs provide 
investors with the opportunity to invest in a diversified basket of 
securities through the purchase of a

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single exchange-traded security.\19\ As a result, investors can have 
the diversification benefits of an investment company with the trading 
flexibility of a stock. In addition, ETF applicants have stated that 
unlike closed-end funds (the traditional type of investment company 
that issues exchange-traded shares), ETFs can avoid the discounts and 
premiums in market price often associated with closed-end fund shares 
by continually issuing and redeeming ETF shares in Creation Units, and 
thereby creating an arbitrage mechanism.\20\
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    \19\ See, e.g., Fourth Amended and Restated Application of SPDR 
Trust, Series 1, File No. 812-7545, filed Aug. 7, 1992 (``SPDR 
Application''), at 42-43. In the SPDR Application, applicants stated 
that SPDRs were developed in response to the suspension of trading 
in ``index participants'' (``IPs''), contracts of indefinite 
duration based on the value of a basket (index) of securities. See 
SPDR Application at p. 45. Trading in IPs was suspended after the 
U.S. Court of Appeals for the Seventh Circuit found that IPs 
represented a futures contract within the exclusive jurisdiction of 
the Commodity Futures Trading Commission. Chicago Mercantile 
Exchange, et al. v. Securities and Exchange Commission, et al., 883 
F.2d 537 (7th Cir. 1989), cert. denied 496 U.S. 936, 110 S. Ct. 3214 
(1990). Because SPDRs represented an interest in an actual portfolio 
of securities, SPDRs did not present the futurity issues of IPs.
    \20\ See, e.g., Fifth Amended and Restated Application of The 
CountyBaskets Index Fund, Inc., File No. 812-9188, filed June 30, 
1995, at 11.
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1. ETFs as a Tool for Individual Investors
    As the ETF marketplace has developed, individual investors 
apparently have accepted ETFs as an index investment with trading 
flexibility.\21\ Certain individual investors reportedly invest in ETF 
shares as a long-term investment for asset allocation purposes, while 
other individual investors apparently trade ETF shares frequently as 
part of market timing investment strategies.\22\ For those investors 
who trade more frequently, ETFs offer the ability to purchase and sell 
ETF shares in the secondary market at a known price anytime during the 
trading day, to purchase ETF shares on margin, and to sell ETF shares 
short.
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    \21\ See, e.g., Lee Barney, Exchange-Traded Funds Continue to 
Grow in 2001, TheStreet.com, May 16, 2001 (``The first and foremost 
reason investors like ETFs is because, like index funds, they offer 
exposure to a variety of sectors. * * *.''), at http://www.thestreet.com/funds/funds,1430991.html; Lee Clifford, All Your 
Stocks in One Basket, Fortune, Mar. 5, 2001, at 200 (explaining how 
ETFs can be useful of tracking an index, balancing a portfolio, or 
gaining exposure to a market segment); Barbara Eisner Bayer, The 
Latest Indexing Craze, Fool.com, June 27, 2000 (``Perhaps the 
greatest benefit of ETFs is that investors will now have instant 
exposure to a diversified portfolio of stocks.''), at http://www.fool.com/Server/FoolPrint.asp?File+/ddow/2000/ddow000627.htm.
    \22\ See, e.g., Aaron Lucchetti, Tradable Shares Bring Some Buzz 
to Mutuals, Wall St. J., June 5, 2000, at R1 (profiling different 
types of ETF investors); Jerry Morgan, ETFs, An Alternative to Index 
Funds, Newsday, Jan. 29, 2000, at F05; John Spence, FRC Study 
Examines Future of ETFs, indexfunds.com, Nov. 6, 2000 (reporting on 
a survey conducted by Financial Research Corporation that found that 
75% of retail investors surveyed who either owned or had inquired 
about ETFs intended to use ETFs primarily for buy-and-hold 
strategies, while 25% intended to use ETFs for a mix of long-term 
and trading strategies), at http://www.indexfunds.com/Pfarticles/
20001106_FRCstudy_iss__etf_JShtm.
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2. The Uses of ETFs for Institutional Investors
    Institutions also may purchase ETF shares in the secondary market 
for a variety of reasons. For example, certain pension funds whose 
investment restrictions preclude investment in index derivatives may 
instead invest in ETF shares.\23\ Other institutions reportedly prefer 
to hold ETF shares instead of index futures because ETF shares do not 
have the margin requirements or expiration dates of futures.\24\ Some 
private investment companies (such as hedge funds) reportedly employ 
ETF shares in hedging strategies by taking certain short or long 
positions in individual securities of a certain market sector, while 
taking opposite positions in ETF shares tracking that sector.\25\ Other 
institutional money managers and mutual funds may use ETFs as a 
temporary means of keeping cash invested in a broad market segment 
during transitions in investment strategy or management.\26\
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    \23\ See, e.g., Elgin, Peggie R., SPDR Web Ensnares Both Active, 
Passive Fund Managers, 14 Corporate Cashflow Magazine, No. 13, Dec. 
1993, at 5.
    \24\ See, e.g., Barney, supra note 21.
    \25\ See, e.g., Allison Bisbey Colter, Exchange-Traded Funds Are 
Booming, Wall St. July 12, 2001, at C19 (noting also that some hedge 
funds use ETF shares instead of index futures to avoid licensing 
requirements of the Commodity Futures Trading Commission).
    \26\ See, e.g., Fred Williams, Interest Accelerates: ETFs: 
Market up 82% to Nearly $76 Billion, Pensions and Investments, Mar. 
5, 2001, at 25.
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3. The Efficiency of ETFs
    ETFs also appear to attract investors as a low-cost and tax 
efficient investment vehicle.\27\ Like index-based mutual funds 
(``index funds''), index-based ETFs are passively managed to track an 
index and do not have significant turnover in portfolio securities. As 
a result, ETF expenses are typically lower than the expenses of 
actively managed mutual funds, which generally have higher management 
fees and brokerage expenses due to portfolio trading. In addition, ETF 
expenses are often lower than the expenses of index funds. Because most 
ETF shareholders purchase and sell ETF shares through secondary market 
transactions rather than through transactions with the ETF, ETFs do not 
have the same degree of shareholder recordkeeping and service expenses 
as index funds.\28\ However, investors who purchase and sell ETF shares 
in secondary market transactions pay brokerage commissions in 
connection with those transactions, which can represent an additional 
cost to investors that is not reflected in the expense ratio of an ETF.
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    \27\ See, e.g., John Spence, Retail Investor Perception of 
Exchange-Traded Funds, indexfunds.com, Feb. 22, 2001 (reporting on 
survey conducted by Financial Research Corporation that found ``tax 
efficiency,'' ``trading and tax flexbility,'' and ``lower expense 
ratios'' to be the three most commonly cited reasons for potential 
interest in ETFs among retail investors), at http://www.indexfunds.com/Pfarticles/20010223_ETFperception_iss-etf-JS.htm; 
Theo Francis, Navigating the New World of ETFs, Wall St. J., May 11, 
2001, at C1; Sara Robinson, A Mutual Fund Rival on the Trading 
Floor, N.Y. Times, Nov. 7, 1999, at 8.
    \28\ See, e.g., Frederick P. Gabriel Jr., ETFs, May Be Losing 
Pricing Edge: Some to Have Fees that Match Top Funds, Investment 
News, Aug. 27, 2001, at 3 (reporting that an analysis by Lipper Inc. 
found only a few examples of index funds that are less expensive 
than ETFs with the same investment objective); Aldo Svaldi, ETFs 
Take Aim at Ailing Mutual Funds, The Denver Post, Mar. 4, 2001, at 
J-03 (reporting that ETFs that track the larger U.S. indices have an 
average annual expense ratio of .34%, compared to .50% for an index 
fund, and 1 to 1.5% for an actively managed mutual fund); Aaron 
Lucchetti, Index Mutual Funds Have a Price War, Wall St. J., at C-1, 
May 12, 2000 (noting that ETFs may have expense advantages over 
index funds because they do not deal directly with individual 
investors through expensive telephone centers and retail offices).
---------------------------------------------------------------------------

    With respect to tax efficiency, ETFs reportedly offer advantages 
over many mutual funds. When a mutual fund sells portfolio securities 
to pursue its investment strategies or to generate cash for shareholder 
redemptions, the mutual fund may realize capital gains if the value of 
the securities increased while they were in the fund portfolio. A 
mutual fund distributes accumulated capital gains to its shareholders, 
and shareholders generally must pay taxes on those distributions. An 
ETF also may accumulate and distribute capital gains to investors. 
However, like index funds, an ETF may be more tax efficient than many 
mutual funds because of the low turnover in its portfolio securities. 
In addition, the ETF structure may allow an ETF to avoid capital gains 
to an even greater extent than index funds. Because an ETF typically 
redeems Creation Units of ETF shares by delivering securities in the 
Redemption Basket, an ETF does not have to sell securities (and 
possibly realize capital gains) in order to pay redemptions in 
cash.\29\ The Redemption

[[Page 57618]]

Basket also may include securities from the ETF portfolio that have the 
highest unrealized capital gains (i.e., securities that have 
appreciated in value the most while in the ETF portfolio). Because the 
ETF may be able to eliminate securities with significant unrealized 
capital gains from its portfolio through the redemption process, the 
ETF may avoid realizing some capital gains if the ETF needs to sell 
securities at a later date to track its index.\30\
---------------------------------------------------------------------------

    \29\ Because an ETF does not have to maintain cash reserves to 
pay redemptions, an ETF also may be able to remain more fully 
invested in the securities of its corresponding index, which could 
help an ETF track its index more effectively than some index funds. 
See, e.g., Albert B. Crenshaw, Funds that Trade Like Stocks; ETFs 
Offer Some Advantages over Traditional Mutuals, Wash. Post, July 9, 
2000, at H02.
    \30\ See, e.g., Karen Damato, Tax Advantages Are Promised by 
Fund Rivals, Wall St. J., Sept. 1, 2000, at C1; Dagen McDowell, 
Exchange-Traded Funds Are Tax-Efficient, but Not Tax Perfect, 
TheStreet.com, Aug. 22, 2000, at http://www.thestreet.com/funds/deardagen/1049339.html.
---------------------------------------------------------------------------

III. The Concept of an Actively Managed ETF

    As noted above, market participants are interested in developing an 
``actively managed ETF''--an ETF with an actively managed portfolio 
that does not seek to replicate the performance of any particular 
market index. Like existing ETFs, an actively managed ETF would be 
registered under the Act (as an open-end fund rather than a UIT, 
because a UIT cannot be managed) and would issue and redeem its shares 
only in Creation Units. The ETF would list its shares on a national 
securities exchange, and investors would trade the ETF shares 
throughout the day at market prices in the secondary market. As with 
index-based ETFs, the ability to buy and redeem Creation Units at NAV 
would present arbitrage opportunities if the market price of the 
individual ETF shares deviated from NAV.
    Despite these general similarities, there may be significant 
structural and operational differences between the two types of 
products.\31\ For example, it is not clear whether an actively managed 
ETF would propose to inform investors of the contents of its portfolio 
in the same manner as index-based ETFs (through the daily announcement 
of the Portfolio Deposit and Redemption Basket).\32\ Because the 
portfolio of an actively managed ETF likely would change more 
frequently and in less foreseeable ways than the portfolio of an index-
based ETF, it is not clear how or whether an actively managed ETF would 
propose to communicate intra-day changes to investors.\33\ This 
potential for less transparency in the portfolio holdings of an 
actively managed ETF may make the process of creating and redeeming 
Creation Units more difficult or present greater investment risk for 
arbitrageurs. As a result, an actively managed ETF could have a less 
efficient arbitrage mechanism than index-based ETFs, which could lead 
to more significant premiums or discounts in the market price of its 
shares.
---------------------------------------------------------------------------

    \31\ As noted above, many of the details regarding the potential 
operations of an actively managed ETF are apparently in development. 
See, e.g., Andrew Greene, AMEX Plans Active Exchange-Traded Fund, 
Mutual Fund Market News, Aug. 14, 2000 (quoting a fund industry 
observer who describes the development of an actively managed ETF as 
``the financial industry's equivalent of the space program back in 
the 1960's'' and states that fund companies and exchanges are 
scrambling to develop something without knowing what it will look 
like).
    \32\ See, e.g., Dagen McDowell, Non-Index Exchange-Traded Funds 
on the Horizon, TheStreet.com, May 16, 2000 (``a stumbling block to 
creating an actively managed [ETF] is the transparency of the 
underlying portfolio * * *. No fund company or fund manager would 
want to reveal everything that's in a fund on a regular basis.'') at 
http://www.thestreet.com/funds/deardagen/940643.html.
    \33\ See, e.g., Lucchetti and Brown, supra note 5 (reporting 
that for an actively managed ETF to be priced continuously 
throughout the day, the ETF manager would have to disclose what the 
ETF was buying and selling during the day, which most active 
managers would not wish to do).
---------------------------------------------------------------------------

    In addition to potential operational differences, an actively 
managed ETF may not have the same uses and benefits as those associated 
with index-based ETFs. As described above, many of the uses of existing 
ETFs, particularly for institutional investors, relate to the fact that 
ETF shares serve as a proxy for an index, which would not be the case 
for ETF shares of actively managed ETFs. In addition, an actively 
managed ETF may have greater turnover in its portfolio securities, 
which could result in higher expenses and less tax efficiency than 
index-based ETFs.\34\
---------------------------------------------------------------------------

    \34\ See, e.g., Michael Santoli, Great Pretenders: New-fashioned 
``Funds'' No Threat to Old Ones, Barron's, Apr. 9, 2001, at F18 
(noting that some observers do not believe that actively managed 
ETFs, will offer the cost and tax benefits of index-based ETFs); 
Scott Cooley, The Time Isn't Right for Actively Managed ETFs, 
Morningstar.com (noting that unless managers reduce portfolio 
trading, an actively managed ETF would not be a tax-efficient 
vehicle) at http://news.morningstar.com/doc/article/01,1,3073,00.html.
---------------------------------------------------------------------------

    We need to consider carefully whether actively managed ETFs are in 
the public interest and consistent with the protection of investors and 
the purposes of the Act before we grant the relief necessary to allow 
for the introduction of these products. To facilitate this process, we 
are seeking public comment on a wide range of issues posed by the 
possible introduction of actively managed ETFs. In addition to the 
specific questions outlined in the following sections, we seek comment 
on these broad issues:
     How are actively managed ETFs likely to be structured, 
managed and operated?
     How will investors use, and benefit from, actively managed 
ETFs?
     Would the exemptive relief that the Commission has granted 
to index-based ETFs be appropriate for actively managed ETFs?
     Are there any new regulatory concerns that might arise in 
connection with actively managed ETFs?

IV. Areas for Comment

A. Index-Based ETFs vs. Actively Managed ETFs

    For purposes of this release, we have 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. Thus, actively managed ETFs would include, for 
example, an ETF that seeks to achieve a multiple (or the reverse) of 
the performance of a market index. Actively managed ETFs also would 
include any ETF that, although it may be using a market index as a 
benchmark for measuring its performance, pursues an investment 
objective that is not tied to the index.
    Is this an appropriate way to distinguish between index-based and 
actively managed ETFs? Are there any reasons to distinguish between 
different types of actively managed ETFs? If there are different types 
of actively managed ETFs, are there any reasons to regulate the various 
types differently?

B. Operational Issues Relating to Actively Managed ETFs

    The unique structure of an ETF--in which investors can buy and 
redeem Creation Units at NAV, and can sell and purchase individual ETF 
shares in the secondary market at market price--is designed, among 
other things, to ensure arbitrage opportunities that would reduce any 
deviations between the NAV and the market price of ETF shares. The 
expectation that the market price of ETF shares would track NAV (and 
the performance of an index) is important to many of the uses of ETF 
shares as index-based securities. An ETF also is thought to offer 
advantages over a closed-end fund structure in which discounts from NAV 
are common. The existing ETFs, as a general matter, have not 
experienced significant deviations between the NAV and the market price 
of their ETF shares.\35\
---------------------------------------------------------------------------

    \35\ See supra note 17.
---------------------------------------------------------------------------

    Is it important that ETFs be designed to enable arbitrage and 
thereby

[[Page 57619]]

minimize the probability that ETF shares will trade at a large premium 
or discount? 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?
    It appears that two factors may contribute significantly to the 
effectiveness of arbitrage in the ETF structure--the transparency of an 
ETF's portfolio and the liquidity of the securities in the ETF's 
portfolio.
1. Transparency of an ETF's Portfolio
    Existing ETFs generally create and redeem Creation Units through 
in-kind transactions. At the beginning of each day, the investment 
adviser or sponsor of the ETF makes available the identities of the 
securities in the Portfolio Deposit and the Redemption Basket 
(generally through the National Securities Clearing Corporation, a 
clearing agency that effects the sales and redemptions of Creation 
Units for many ETFs). These baskets generally reflect the contents of 
the portfolio of the ETF on that day and do not change during the 
day.\36\ In addition, the listing exchange makes available the current 
value of the Portfolio Deposit on a per ETF share basis at 15 second 
intervals throughout the day and disseminates intra-day values of the 
relevant index. This high degree of transparency in the investment 
operations of an ETF helps arbitrageurs determine whether to purchase 
or redeem Creation Units based on the relative values of the ETF shares 
in the secondary market and the securities contained in the ETF's 
portfolio.
---------------------------------------------------------------------------

    \36\ Because an index-based ETF seeks to track the performance 
of an index, often by replicating the component securities of the 
index, the ETF investment adviser or sponsor has no reservations 
about informing the marketplace of the contents of the ETF's 
portolio.
---------------------------------------------------------------------------

    What level of transparency in portfolio holdings is necessary to 
allow for effective arbitrage activity in the shares of an actively 
managed ETF? Should an actively managed ETF be required to disclose the 
full contents of its portfolio? Is it sufficient for an actively 
managed ETF to disclose only a sample of its portfolio or the general 
characteristics of its portfolio? Can effective arbitrage occur without 
any disclosure of the specific securities in an ETF's portfolio (i.e., 
arbitrage that is based strictly on the NAV and market price of ETF 
shares)?
    How frequently would the investment adviser of an actively managed 
ETF need to disclose the portfolio securities or characteristics of the 
ETF portfolio? Would an investment adviser need to disclose intra-day 
changes in the portfolio of an actively managed ETF? Would there be a 
need to permit or require the specified Portfolio Deposit or Redemption 
Basket to change during the day to reflect changes in the ETF's 
portfolio? If so, what type of notice would be necessary to inform 
investors of any changes to the Portfolio Deposit or Redemption Basket 
in the course of a day? Are intra-day values of the Portfolio Deposit 
meaningful to investors if investors do not know the contents of the 
ETF portfolio?
    Would frequent disclosure of portfolio holdings lead to ``front 
running'' of the ETF portfolio, where other investors would trade ahead 
of the ETF and the Creation Unit purchasers who must assemble Portfolio 
Deposits? \37\ Would frequent disclosure of portfolio holdings lead to 
``free riding,'' where other investors would mirror the investment 
strategies of an actively managed ETF while the ETF investors pay the 
advisory fees? Would an investment adviser to an actively managed ETF 
face a conflict between maximizing performance and facilitating 
arbitrage by informing the marketplace of the adviser's investment 
strategies (e.g., would there be a reluctance on the part of a 
portfolio manager to make frequent adjustments in the portfolio because 
of the possible impact on the arbitrage mechanism)?
---------------------------------------------------------------------------

    \37\ See, e.g., Hayashi, supra note 9 (stating that disclosure 
of the portfolio of an actively managed ETF could lead to front 
running and create unwanted demand for the stocks identified by the 
ETF for inclusion in its portfolio).
---------------------------------------------------------------------------

2. Liquidity of Securities in an ETF's Portfolio
    Existing ETFs track various equity indices including foreign and 
domestic indices, broad-based indices, and sector indices. All of the 
indices have specified methodologies for selecting their component 
securities. The methodologies generally ensure that an index consists 
of a certain number of component securities, and that those securities 
will have significant market capitalization and will be actively 
traded. Because ETFs either replicate or sample the indices, their 
portfolio securities also should possess these characteristics. 
Effective arbitrage depends in part upon the ability of investors to 
readily assemble the Portfolio Deposit for purchases of Creation Units 
and to sell securities received upon redemption of Creation Units. The 
liquidity of portfolio securities is an important factor in this 
process.
    Should actively managed ETFs be limited to certain investment 
objectives or policies that are designed to ensure that the portfolio 
securities are sufficiently liquid to permit effective arbitrage? If 
so, what types of parameters are necessary to ensure that an ETF 
invests in securities that can be readily purchased or sold by 
arbitrageurs? Should an actively managed ETF be permitted to invest in 
securities other than equity securities? Should an actively managed ETF 
be permitted to invest in any illiquid securities or securities that 
could not be included in a Portfolio Deposit or Redemption Basket? 
Should an actively managed ETF be prohibited from investing in 
securities that are not registered under section 12 of the Exchange 
Act? \38\ Should an actively managed ETF be prohibited from investing 
in securities that are part of an ``unsold allotment'' within the 
meaning of section 4(3)(C) of the Securities Act? \39\
---------------------------------------------------------------------------

    \38\ 15 U.S.C. 78l.
    \39\ 15 U.S.C. 77d(3)(C).
---------------------------------------------------------------------------

    Is it necessary for an actively managed ETF to create and redeem 
Creation Units through in-kind transactions (rather than cash 
transactions)? \40\ Would there be any consequences to permitting cash 
purchases and redemptions of Creation Units for an actively managed 
ETF? Could the cash component of a Portfolio Deposit or Redemption 
Basket be used to account for portfolio securities that could not be 
included in a Portfolio Deposit or Redemption Basket? \41\
---------------------------------------------------------------------------

    \40\ Though existing ETFs primarily transact in-kind, they 
generally reserve the possibility of cash purchases and redemptions 
under certain circumstances, such as on days when a substantial 
rebalancing of an ETF's portfolio is required. See, e.g., Barclays 
Application at 23-24. Certain iShares ETFs that invest in certain 
foreign markets currently effect creations and redemptions through 
cash transactions.
    \41\ Most ETFs currently reserve the possibility that cash may 
be substituted for certain securities in a Portfolio Deposit or 
Redemption Basket under unusual circumstances, such as when an 
investor who purchases or redeems a Creation Unit is not permitted 
to transact in particular securities. See, e.g., Barclays 
Application at 28-29.
---------------------------------------------------------------------------

3. Other Operational Issues
    What other issues could cause an actively managed ETF to operate 
differently than an index-based ETF? Would the clearance and settlement 
procedures for Creation Unit transactions for actively managed ETFs be 
the same as for index-based ETFs? Are there other operational issues 
that could affect the willingness of investors to purchase shares of an 
actively managed ETF either on the secondary market or in Creation 
Units from the ETF? Would significant deviations

[[Page 57620]]

between the market price of shares of an actively managed ETF and the 
NAV of the ETF shares compromise the operations of the ETF?

C. Uses, Benefits and Risks of Actively Managed ETFs

    As noted, in granting exemptions under section 6(c), the Commission 
must find that the 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.\42\ 
The Commission is interested in learning about the ways in which 
investors may use actively managed ETFs and the benefits that this new 
investment product may be expected to bring. The Commission also is 
seeking comment generally on any aspects of actively managed ETFs that 
may be relevant to the determination that the Commission would be 
making under section 6(c).
---------------------------------------------------------------------------

    \42\ See supra note 10.
---------------------------------------------------------------------------

    In determining whether the relief we have granted to permit ETFs 
should be expanded to permit actively managed ETFs, we think it is 
appropriate to consider the uses and benefits of existing index-based 
ETFs, as well as any concerns regarding ETFs generally. What are the 
most important uses and benefits of index-based ETFs? Have index-based 
ETFs encountered any problems of which the Commission should be aware 
in evaluating future ETF proposals? \43\ Are investors confused about 
the differences between ETFs and mutual funds? What measures could be 
taken to address any potential investor confusion? Does trading in ETF 
shares have any relation to market volatility, and if so, in what ways? 
\44\ Has the introduction of ETFs generally led to any undesirable 
consequences for investors?
---------------------------------------------------------------------------

    \43\ See, e.g., Karen Damato and Aaron Lucchetti, Critics Worry 
About Risks of Exchange-Traded Funds, Wall St. J., July 7, 2000, at 
C1 (reporting on criticism that ETFs may not disclose adequate 
information about the potential for ETF shares to trade at a premium 
or discount to NAV).
    \44\ See Carol Vinzant, NASDAQQQ: Trading in ``Cubes'' is 
Skyrocketing, and Some Critics Fear the Nasdaq 100-Based vehicles 
Are Contributing to Volatility;, Wash. Post, May 10, 2001, at E1 
(reporting that some critics believe trading in cubes has increased 
market volatility).
    But see The October 1987 Market Break, A Report by the Division 
of Market Regulation, U.S. Securities and Exchange Commission, Feb. 
1988, at 3-18 (suggesting that market basket trading could provide 
an additional layer of liquidity in the market that could reduce 
volatility).
---------------------------------------------------------------------------

    With respect to the potential for actively managed ETFs, should 
investors expect that any mutual fund could be transformed into an ETF, 
or would only certain types of actively managed portfolios lend 
themselves to the ETF structure? Would closed-end funds seek to convert 
into actively managed ETFs as a possible means of addressing discounts 
in share price? \45\ Why would an actively managed ETF be a desirable 
alternative to a mutual fund or closed-end fund that pursues the same 
investment objectives or strategies?
---------------------------------------------------------------------------

    \45\ See, e.g., Aaron Lucchetti, In Closed-ends, a Possible Way 
to Get Rid of Discounts to NAV, Wall St. J., Apr. 10, 2000, at R14 
(reporting on idea to convert closed-end funds to ETFs to eliminate 
discounts in share prices).
---------------------------------------------------------------------------

    What would be the principal uses of actively managed ETFs by 
investors? Would an actively managed ETF serve primarily as a short-
term trading vehicle? Could an actively managed ETF be used to gain 
exposure to an asset category in a manner similar to index-based ETFs? 
Would an actively managed ETF have any role in hedging strategies? 
Would an actively managed ETF appeal more to individual investors or 
institutional investors?
    What would be the principal benefits of actively managed ETFs? 
Would an actively managed ETF possess the low expenses and tax 
efficiency associated with existing ETFs? Would the introduction of 
actively managed ETFs be detrimental to investors, and if so, how? 
Would investors be confused about the nature of actively managed ETFs? 
Could actively managed ETFs lead to greater market volatility? \46\ Is 
the development of actively managed ETFs important for U.S. financial 
institutions to maintain a competitive position in global securities 
markets? \47\
---------------------------------------------------------------------------

    \46\ See, e.g., Andrew Brent, SEC Guidance Expected for Exchange 
Funds, Mutual Fund Market News, May 28, 2001 (reporting that some 
analysts believe there are several scenarios in which an actively 
managed ETF could cause increased market volatility).
    \47\ A type of actively managed exchange-traded investment 
company was introduced by Deutsche Bank in Germany in November 2000 
and has reportedly experienced some success among retail investors 
in Germany. See, e.g., Stephan Kueffner, Exchange-Traded Funds Make 
Their Mark in German Market, Capital Markets Report, April 23, 2001. 
As a general matter, investment companies that are not organized or 
created under the laws of the United States cannot offer, sell, or 
deliver shares to investors in the United States unless they obtain 
an order of the Commission. 15 U.S.C. 80a-7(d).
---------------------------------------------------------------------------

D. Exemptive Relief From the Investment Company Act for Actively 
Managed ETFs

    Because of their unique structure, ETFs must obtain exemptive 
relief from certain provisions of the Act. An ETF organized as an open-
end fund generally requests an order (i) under section 6(c) of the Act 
granting relief from sections 2(a)(32) and 5(a)(1) of the Act so that 
the ETF may register under the Act as an open-end fund and issue shares 
that are redeemable in Creation Units only; (ii) under section 6(c) 
granting relief from section 22(d) of the Act and rule 22c-1 under the 
Act to permit the purchase and sale of individual ETF shares in the 
secondary market at negotiated prices; and (iii) under sections 6(c) 
and 17(b) of the Act granting relief from sections 17(a)(1) and (a)(2) 
of the Act to permit in-kind purchases and redemptions of Creation 
Units by persons who may be affiliated with the ETF by reason of owning 
more than 5%, and in some cases more than 25%, of its outstanding 
securities. Certain ETFs that track foreign indices also have obtained 
relief under section 6(c) from section 22(e) of the Act so that they 
may satisfy redemption requests more than seven days after the tender 
of a Creation Unit for redemption due to delivery cycles for securities 
in the local markets.
    Because actively managed ETFs necessarily would be organized as 
open-end funds (rather than as UITs with fixed portfolios), these ETFs 
likely would seek exemptive relief from the same provisions of the Act 
as existing ETFs that are organized as open-end funds. In considering 
whether to grant relief from each of the sections outlined above 
pursuant to section 6(c), the Commission must find that the 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.\48\ Under section 17(b), the 
Commission may exempt a proposed transaction from section 17(a) if 
evidence establishes that the terms of the transaction, including the 
consideration to be paid or received, are reasonable and fair and do 
not involve overreaching, and the proposed transaction is consistent 
with the policies of the registered investment company and the general 
provisions of the Act.\49\ In evaluating any exemptive applications to 
permit actively managed ETFs, we would assess whether these exemptive 
standards are met.
---------------------------------------------------------------------------

    \48\ See supra note 10.
    \49\ 15 U.S.C. 80a-17(b)
---------------------------------------------------------------------------

1. Relief for ETFs To Redeem Shares in Large Aggregations Only
    Section 5(a)(1) defines an ``open-end company'' as a management 
investment company that is offering for sale or has outstanding any 
redeemable security of which it is the issuer.\50\ Section 2(a)(32) 
defines a redeemable security as any security, other than short-term 
paper, under the terms of which the holder, upon its presentation to 
the issuer, is

[[Page 57621]]

entitled to receive approximately the holder's proportionate share of 
the issuer's current net assets, or the cash equivalent.\51\ Because 
ETF shares are not individually redeemable, an ETF requests relief to 
permit the ETF to register and operate as an open-end fund and to issue 
shares that are redeemable in Creation Units only.
---------------------------------------------------------------------------

    \50\ See supra note 6.
    \51\ 15 U.S.C. 80a-2(a)(32).
---------------------------------------------------------------------------

    In support of the relief, ETFs have noted that investors may redeem 
ETF shares in Creation Units from each ETF. ETFs also have noted that 
because the market price of Creation Units is disciplined by arbitrage 
opportunities, investors in ETF shares generally should be able to sell 
ETF shares in the secondary market at approximately their NAV. ETFs 
organized as open-end funds have agreed as a condition to the exemptive 
relief that the ETF will not be advertised or marketed as an open-end 
fund or mutual fund. The prospectuses and advertising materials for 
ETFs prominently disclose that ETF shares are not individually 
redeemable and that shareholders may acquire shares from an ETF and 
tender those shares for redemption to the ETF in Creation Units 
only.\52\
---------------------------------------------------------------------------

    \52\ See, e.g., Barclays Application at 63-70, 81.
---------------------------------------------------------------------------

    Would actively managed ETFs present any issues with respect to 
these exemptions that do not exist with respect to index-based ETFs? 
Should the potential for more significant deviations between the market 
price of actively managed ETF shares and the NAV of the shares affect 
any relief requested from the definition of ``redeemable security''? 
Are greater disclosure efforts necessary to address any potential 
investor confusion regarding the nature of actively managed ETFs and 
their shares?
2. Relief for ETF Shares To Trade at Negotiated Prices
    Section 22(d), among other things, prohibits a dealer from selling 
a redeemable security that is being currently offered to the public by 
or through an underwriter, except at a current public offering price 
described in the prospectus.\53\ Rule 22c-1 generally requires that a 
dealer selling, redeeming, or repurchasing a redeemable security do so 
only at a price based on its NAV.\54\ Because secondary market trading 
in ETF shares takes place at negotiated prices, and not at a current 
offering price described in the prospectus or based on NAV, existing 
ETFs have obtained exemptions from section 22(d) and rule 22c-1.
---------------------------------------------------------------------------

    \53\ 15 U.S.C. 80a-22(d).
    \54\ 17 CFR 270.22c-1
---------------------------------------------------------------------------

    In support of their requests for relief, ETFs generally have noted 
that the provisions of section 22(d), as well as rule 22c-1, appear to 
be designed to prevent dilution caused by certain riskless-trading 
schemes by principal underwriters and contract dealers, to prevent 
unjust discrimination or preferential treatment among buyers resulting 
from sales at different prices, and to assure an orderly distribution 
of investment company shares by eliminating price competition from 
dealers offering shares at less than the published sales price and 
repurchasing shares at more than the published redemption price. The 
ETFs submit that secondary market trading in ETF shares does not cause 
dilution for ETF shareholders because the secondary market transactions 
do not directly involve ETF portfolio assets (the transactions are with 
other investors, not the ETF), and thus have no impact on the NAV of 
ETF shares held by other investors. In addition, ETFs have stated that 
to the extent that different prices for ETF shares exist during a given 
trading day, or from day to day, these variances occur as a result of 
third-party market forces, such as supply and demand, and not as a 
result of discrimination or preferential treatment among purchasers. 
With respect to the orderly distribution of ETF shares, ETFs have noted 
that anyone may acquire Creation Units from the ETF, and that no dealer 
should have an advantage over any other dealer in the sale of ETF 
shares. ETFs also have argued that the distribution system for ETF 
shares should be orderly because arbitrage activity ensures that the 
difference between the market price of shares and their NAV remains 
narrow.\55\
---------------------------------------------------------------------------

    \55\ See, e.g., Barclays Application at 70-74.
---------------------------------------------------------------------------

    Would actively managed ETFs present any issues with respect to 
these exemptions that do not exist with respect to index-based ETFs? 
Would the potential for more significant deviations between the market 
price of actively managed ETF shares and the NAV of the shares create 
any potential for discrimination or preferential treatment among 
investors purchasing and selling shares in the secondary market and 
those purchasing and redeeming Creation Units? Would more significant 
deviations lead to a less orderly distribution system for actively 
managed ETF shares? Are greater disclosure efforts necessary to address 
potential investor confusion regarding the fact that individual shares 
of actively managed ETFs would be sold at market price while Creation 
Unit aggregations of ETF shares would be redeemable at NAV?
3. Relief for In-Kind Transactions Between an ETF and Certain 
Affiliates
    Section 17(a) of the Act generally prohibits an affiliated person 
of a registered investment company, or an affiliated person of such 
person, from selling any security to or purchasing any security from 
the company.\56\ Because purchases and redemptions of Creation Units 
may be in-kind rather than cash transactions, section 17(a) may 
prohibit affiliated persons of an ETF from purchasing or redeeming 
Creation Units. Section 2(a)(3)(A) of the Act defines ``affiliated 
person'' as any person owning 5% or more of an issuer's outstanding 
voting securities. ETFs indicate that certain large investors may be 
affiliated persons of an ETF under section 2(a)(3)(A) of the Act (``5% 
Affiliates''). In addition, some investors may own more than 25% of an 
ETF's outstanding voting securities and therefore may be deemed an 
affiliated person of the ETF under section 2(a)(3)(C) of the Act (``25% 
Affiliates'').\57\ ETFs have obtained exemptions from section 17(a) to 
permit 5% Affiliates and 25% Affiliates to purchase and redeem Creation 
Units through in-kind transactions.
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    \56\ 15 U.S.C. 80a-17(a).
    \57\ 15 U.S.C. 80a-2(a)(3).
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    In seeking this relief, ETFs have submitted that because 5% 
Affiliates and 25% Affiliates are not treated differently from non-
affiliates when engaging in purchases and redemptions of Creation 
Units, there is no opportunity for these affiliated persons to effect a 
transaction detrimental to the other ETF shareholders. The securities 
to be deposited for purchases of Creation Units and to be delivered for 
redemptions of Creation Units are announced at the beginning of each 
day and are equally applicable to all investors. All purchases and 
redemptions of Creation Units are at an ETF's next calculated NAV, and 
the securities deposited or received upon redemption are valued in the 
same manner, using the same standards, as those securities are valued 
for purposes of calculating the ETF's NAV.\58\
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    \58\ See, e.g., Barclays Application at 74-79.
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    Would actively managed ETFs present any issues with respect to this 
exemption that do not exist with respect to index-based ETFs? If an 
actively managed ETF proposed to alter the contents of its Portfolio 
Deposit or Redemption Basket during the day to reflect changes in its 
portfolio, would this process introduce the potential to

[[Page 57622]]

favor affiliated persons of the ETF? If so, how should this be 
addressed? Could a 5% Affiliate or 25% Affiliate influence decisions by 
the investment adviser to an actively managed ETF regarding the 
securities in the Portfolio Deposit or Redemption Basket on a given 
day? Would the structure of an actively managed ETF present greater 
concerns with respect to potential advance communication of information 
about portfolio changes to affiliates?
4. Relief for Certain ETFs To Redeem Shares in More Than Seven Days
    Section 22(e) of the Act generally prohibits a registered open-end 
investment company from suspending the right of redemption, or 
postponing the date of payment or satisfaction of redemption requests 
more than seven days after the tender of a security for redemption.\59\ 
Some ETFs that track foreign indices have stated that local market 
delivery cycles for transferring securities to redeeming investors, 
together with local market holiday schedules, require a delivery 
process in excess of seven days. These ETFs request relief from section 
22(e) so that they may satisfy redemptions up to a specified maximum 
number of calendar days depending upon specific circumstances in the 
local markets, as disclosed in the ETF's prospectus or statement of 
additional information (``SAI''). Other than in the disclosed 
situations, these ETFs satisfy redemptions within seven days.\60\
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    \59\ 15 U.S.C. 80a-22(e).
    \60\ In their applications, ETFs acknowledge that no relief 
obtained from the requirements of section 22(e) will affect any 
obligations that they may otherwise have under rule 15c6-1 under the 
Exchange Act. See, e.g., Second Amended and Restated Application of 
Barclays Global Fund Advisors, File No. 812-11598, filed May 11, 
2001 (``Barclays Foreign Application'') at 76. Rule 15c6-1 requires 
that most securities transactions be settled within three business 
days of the trade date. 17 CFR 240.15c6-1
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    These ETFs state in their exemptive applications that section 22(e) 
of the Act is designed to prevent unreasonable, undisclosed, and 
unforeseen delays in the payment of redemption proceeds and assert that 
the requested relief will not lead to the problems that section 22(e) 
was designed to prevent. The anticipated delays in the payment of 
redemption proceeds would occur principally due to local holidays in 
the foreign markets. The ETFs state that the SAI will disclose those 
local holidays (over the period of at least one year following the date 
of the SAI) that are expected to prevent the delivery of redemption 
proceeds in seven days and the maximum number of days needed to deliver 
redemption proceeds.\61\
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    \61\ See, e.g., Barclays Foreign Application at 76-84.
    \62\ 15 U.S.C. 80a-1(b)(3).
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    Would actively managed ETFs present any issues with respect to this 
exemption that do not exist with respect to index-based ETFs? Could the 
investment adviser to an actively managed ETF manage the ETF so as to 
comply with section 22(e)?

E. Potential New Regulatory Issues

    In evaluating any specific proposal for an actively managed ETF, 
the Commission will be considering whether the proposal presents any 
new regulatory concerns. In this regard, we are interested in public 
comment on the issues raised below, as well as any additional issues 
that might be identified by the commenters.
1. Potential Discrimination Among Shareholders
    Section 1(b)(3) of the Act states that the public interest and the 
interest of investors are adversely affected when investment companies 
issue securities containing inequitable or discriminatory 
provisions.\62\ One potential difference between the existing ETFs and 
an actively managed ETF is that, in the latter case, significant 
deviations could develop between the market price and the NAV of the 
ETF shares. It might also be possible that, during any particular time, 
the NAV of an actively managed ETF could be increasing while the market 
price of its shares could be falling, and vice versa.
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    \62\ 15 U.S.C. 80a-1(b)(3).
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    Would the operation of an actively managed ETF place investors who 
have the financial resources to purchase or redeem a Creation Unit at 
NAV in a different position than most retail investors who may buy and 
sell ETF shares only at market price? Would the operation of an 
actively managed ETF give rise to a type of discriminatory treatment of 
shareholders that section 1(b)(3) of the Act was designed to prevent? 
Commenters who believe that this concern might be raised by an actively 
managed ETF are encouraged also to discuss the ways in which they 
believe the Commission should address it.
2. Potential Conflicts of Interest for an ETF's Investment Adviser
    Section 1(b)(2) of the Act states that the public interest and the 
interest of investors are adversely affected when investment companies 
are organized, operated, managed, or their portfolio securities are 
selected, in the interest of persons other than shareholders, including 
directors, officers, investment advisers, or other affiliated persons, 
and underwriters, brokers, or dealers.\63\ The operation of an ETF--
specifically, the process in which a Creation Unit is purchased by 
delivering a basket of securities to the ETF, and redeemed in exchange 
for a basket of securities--may lend itself to certain conflicts for 
the ETF's investment adviser, who has discretion to specify the 
securities included in the baskets. These conflicts would appear to be 
minimized in the case of an index-based ETF because the universe of 
securities that may be included in the ETF's portfolio generally is 
restricted by the composition of its corresponding index. The same 
would not appear to be the case for an actively managed ETF. The 
increased investment discretion of the adviser to an actively managed 
ETF would seem to increase the potential for conflicts of interest. For 
example, an adviser to an index-based ETF would have little ability to 
create a market for certain securities in a way that would favor an 
affiliate. Because the adviser to an actively managed ETF would have 
greater discretion to designate securities to be included in the 
Portfolio Deposit or Redemption Basket, a greater potential for 
conflicts appears to exist.
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    \63\ 15 U.S.C. 80a-1(b)(2).
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    What potential conflicts of interest would exist for the investment 
adviser to an actively managed ETF? Would the adviser to an actively 
managed ETF be in a position to create supply or demand for securities 
that would favor an affiliate by designating those securities for 
inclusion in the daily Portfolio Deposit or Redemption Basket? Would 
the increased value of the information regarding the identity of future 
deposit or redemption securities create additional conflicts and 
potential for abuse? What measures should be taken to address any 
potential conflicts?
3. Prospectus Delivery in Connection With Secondary Market Purchases
    Open-end funds and UITs are required to deliver a prospectus in 
connection with a sale of their shares. Specifically, section 24(d) of 
the Act provides, in relevant part, that the prospectus delivery 
exemption provided to dealer transactions by section 4(3) of the 
Securities Act does not apply to any transaction in a redeemable 
security issued by an open-end fund or UIT.\64\ For transactions in ETF 
shares in the secondary market, the Commission has granted exemptions 
under section 6(c) of the Act from section 24(d) to permit

[[Page 57623]]

dealers selling shares of certain ETFs to rely on the prospectus 
delivery exemption provided by section 4(3) of the Securities Act.\65\ 
ETFs that have received this relief continue to be subject to 
prospectus delivery requirements in connection with sales of Creation 
Units and transactions involving an underwriter.
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    \64\ 15 U.S.C. 80a-24(d); 15 U.S.C. 77d(3).
    \65\ See, e.g., SPDR Order.
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    In support of the relief, applicants have noted that the ETF shares 
would be listed on a national securities exchange and would be traded 
in a manner similar to shares of closed-end funds, for which dealers 
selling shares in the secondary market generally are not required to 
deliver a prospectus. These ETFs also have agreed that dealers selling 
their shares will provide investors with a ``product description'' 
describing the ETF and its shares.\66\ While not intended as a 
substitute for a prospectus, the product description contains 
information about the ETF shares that is tailored to meet the needs of 
investors purchasing the shares in the secondary market. The product 
description provides a plain English description of the salient 
features of the ETF shares, including the fact that the shares are 
index-based securities, the manner in which the ETF shares trade on the 
secondary market, and the manner in which Creation Units are purchased 
and redeemed. The product description discloses that the ETF shares are 
not redeemable individually, and that an investor selling the shares in 
the secondary market may receive less than the NAV of the ETF 
shares.\67\
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    \66\ ETFs that possess relief from section 24(d) are listed on 
the American Stock Exchange, which has adopted rules requiring the 
delivery of product descriptions. See American Stock Exchange 
Constitution and Rules & Arbitration Awards, Rules 1000 and 1000A.
    \67\ See, e.g., SPDR Applicaiton at 82-98.
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    To the extent that actively managed ETFs would seek similar relief 
from prospectus delivery requirements, would the relief be consistent 
with the public interest and the protection of investors? Are there any 
aspects of an actively managed ETF that would make this relief 
inappropriate? For example, should an actively managed ETF be required 
to deliver its prospectus in order to communicate its investment 
strategy or fundamental policies? If the relief is granted on the 
condition that actively managed ETFs provide investors with a product 
description, what information about an actively managed ETF is 
particularly important to include or highlight in the product 
description?

F. The Concept of an Actively Managed ETF as a Class of a Mutual Fund

1. Multiple Class Open-End Funds
    Open-end funds often offer multiple classes of shares representing 
interests in the same portfolio of securities. An open-end fund may 
establish a multiple class arrangement generally to offer investors a 
choice of methods for paying distribution costs or to allow the fund to 
use alternative distribution channels more efficiently. For example, a 
fund may offer a class of shares that carries only a front-end sales 
load, and another class that carries a deferred sales load and an 
asset-based distribution fee (known as a ``rule 12b-1 fee'' because it 
is permitted by rule 12b-1 under the Act) \68\.
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    \68\ 17 CFR 270.12b-1.
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    A multiple class arrangement requires an exemption from sections 
18(f)(1) and 18(i) of the Act.\69\ Rule 18f-3 under the Act provides 
that exemption and establishes a framework governing the multiple class 
arrangements of open-end funds.\70\ Rule 18f-3 addresses issues that 
may create various conflicts among the different classes of shares of a 
fund. One requirement of rule 18f-3 is that, other than certain 
differences allowed by the rule, each class must have the same rights 
and obligations as each other class.
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    \69\ Section 18(f)(1) of the Act, in relevant part, prohibits an 
open-end fund from issuing any class of ``senior security,'' which 
includes any stock of a class having a priority over any other class 
as to the distribution of assets or the payment of dividends. 15 
U.S.C. 80a-18(f)(1). Section 18(i) of the Act requires that every 
share of stock issued by an open-end fund be voting stock, with the 
same voting rights as every other outstanding voting stock. 15 
U.S.C. 80a-18(i).
    \70\ 17 CFR 270.18f-3.
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2. An Index-Based ETF as a Class of an Existing Open-End Fund
    In December 2000, the Commission issued the first order to permit 
certain existing index funds to create a class of shares (``ETF 
class'') that would be listed on a national securities exchange and 
traded in the secondary market at negotiated prices in the same manner 
as shares of ETFs (``ETF Class Order'').\71\ By creating an ETF class, 
the index funds hope to provide short-term investors and market timers 
with an attractive means of purchasing shares that can be bought and 
sold continuously throughout the day at market prices.\72\ In their 
exemptive application, the index funds stated that the purchase and 
redemption requests by short-term investors in the conventional classes 
increase a fund's realization of capital gains, increase fund expenses, 
and hinder a fund's ability to achieve its investment objective of 
tracking its index. Because transactions in the individual shares of 
the ETF class would occur in the secondary market, these transactions 
would not involve the funds, and as a result, would not disrupt the 
funds' portfolio management or increase the funds' transaction 
costs.\73\
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    \71\ Vanguard Index Funds, Investment Company Act Rel. Nos. 
24680 (Oct. 6, 2000) (notice) and 24789 (Dec. 12, 2000) (order).
    \72\ Transactions in an index fund's conventional shares would 
continue to be priced at that day's NAV. The purchase and redemption 
of Creation Units also would be priced at NAV.
    \73\ Application and Vanguard Index Funds, File No. 812-12094, 
filed July 12, 2000 (``Vanguard Application''), at 6-8.
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    In the ETF Class Order, exemptive relief from sections 18(f)(1) and 
18(i) of the Act was required because, among other reasons, the index 
funds stated that the conventional shares and exchange-traded shares 
would have certain different rights.\74\ For example, the conventional 
shares would be individually redeemable from the fund, while exchange-
traded shares would be redeemable only in Creation Units. In addition, 
the exchange-traded shares would be traded in the secondary market, 
while conventional shares would not. The funds asserted that these 
different rights were necessary for the proposal to have the desired 
benefits, and that the different rights did not implicate the concerns 
underlying section 18 of the Act, including conflicts of interest and 
investor confusion. With respect to the potential for investor 
confusion, the funds agreed to take a variety of steps to ensure that 
investors understand the key differences between the classes of 
exchange-traded shares and conventional shares.\75\
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    \74\ In addition to relief from section 18, the ETF Class Order 
also granted the exemptive relief typically obtained by index-based 
ETFs organized as open-end funds and prospectus delivery relief.
    \75\ Vanguard Application at 36-47.
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3. ETF Class of an Actively Managed Open-End Fund
    Would actively managed mutual funds seek to introduce exchange-
traded classes? Do short-term investors such as market timers and day 
traders use actively managed funds in the same way that they use index 
funds? If not, are there different reasons to permit existing actively 
managed mutual funds to establish ETF classes?
    Would ETF classes of actively managed funds present any issues with 
respect to exemptions from section 18 that do not exist with respect to 
ETF classes of index funds? Would the portfolio disclosure required to 
make fund operations transparent for

[[Page 57624]]

purposes of the ETF class prove detrimental to the performance of the 
conventional shares? Would significant redemptions of conventional 
shares create undesirable tax consequences for ETF class shareholders? 
Would the existence of an ETF class add volatility to an actively-
managed fund? Is there any additional potential for conflicts of 
interest in connection with an ETF class of an actively managed fund?
    Is there additional potential for investor confusion about the 
nature of the ETF class shares? How would potential investor confusion 
be addressed? Would prospectus delivery relief be appropriate in 
connection with ETF classes of actively managed funds, and if so, what 
information should be included in the product description?

V. Solicitation of Additional Comments

    In addition to the areas for comment identified above, we are 
interested in any other issues that commenters may wish to address 
relating to actively managed ETFs. Please be as specific as possible in 
your discussion and analysis of any additional issues.

    By the Commission.

    Dated: November 8, 2001.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-28572 Filed 11-14-01; 8:45 am]
BILLING CODE 8010-01-P