The Securities and Exchange Commission is looking at a rule that would make it more difficult for asset managers to create exchange-traded funds that cover esoteric, illiquid investments.
The rule would hold ETF pro-viders to their claims that an ETF traded at or close to its net asset value. It is unclear how exactly the rule would do that, however.
“It may be a tool to deal with some of the newer iterations [of ETFs] that are coming up,” Andrew J. “Buddy” Donohue, director of the SEC's Division of Investment Management, said last week at an Investment Company Institute conference in Phoenix.
At this time, only “authorized participants,” principally exchange traders who are charged with ensuring that an ETF's intraday market price approximates its NAV, can trade shares directly with an ETF.
In ETFs that cover broad swaths of the market, the trading activities of authorized participants are sufficient to keep ETF share prices in sync with the fund's underlying shares. But premiums and discounts between an ETF's NAV and its share price can be wide in cases where the underlying stocks themselves are thinly traded.
When an ETF trades at a persistent premium or discount to its NAV, authorized participants have an advantage over retail investors be-cause they are the only ones who can profit from arbitrage opportunities.
It is an advantage that “can work to the detriment of small investors who don't ... have the ability to get the net asset value of the fund,” Mr. Donohue said.
His comments make sense, said Paul Justice, an ETF strategist with Morningstar Inc.
“[Language in the new rule] may be a tool to deal with some of the newer iterations [of ETFs] that are coming up,” Mr. Justice said.
“There are some markets where best execution is not possible,” he said, noting that in those markets, an ETF may trade at a premium or discount to NAV.
But in many cases, closed-end funds trade at premiums and discounts that are far greater than those of ETFs, Mr. Justice said.
For example, as of March 17, the Direxion Daily Semiconductor Bear 3X Shares (SOXS), offered by Direxion Funds, was trading at a premium of 3.6%, the highest premium of any ETF, while the Pimco Global Stocksplus & Income Fund (PGP), from Pacific Investment Management Co. LLC, was trading at a premium of 50.12%, the highest of any closed-end fund.
At the same time, the iShares MSCI Far East Financials Sector Index Fund (FEFN), from iShares Funds, was trading at a discount of 6.49%, the largest discount of any ETF, according to Morningstar, while the Equus Total Return Inc.'s Common Fund (EQS) was trading at a discount of 51.28%, the largest of any closed-end fund.
ETFs have made greater im-provements in their ability to trade more closely to their NAVs than have closed-end funds, Mr. Justice said.
And fears that authorized participants are somehow getting rich at the expense of retail-ETF investors when discounts or premiums widen are unfounded, said Herb Blank, an ETF industry consultant and senior vice president of Rapid Ratings International Inc.
Any arbitrage conducted by authorized participants actually helps the investor because it works to narrow any discount or premium, he said.
The strong points of ETFs aren't the issue, Mr. Donohue said.
“People have every business incentive to have that [arbitrage mechanism] work,” he said. “But while people have a business incentive to make it work, I have a regulatory incentive to make sure it works.”
Financial advisers said that they are pleased with Mr. Donohue's position.
Fears that authorized participants may have an advantage at the expense of retail investors aren't necessarily overblown, said Richard Romey, president and founder of ETF Portfolio Solutions Inc., which manages more than $50 million in assets.
“When you start moving to asset classes that are harder to price, you clearly give an advantage to big institutions,” he said.
Unfortunately, product development of ETFs appears to be moving in the direction of more obscure, more illiquid assets, Mr. Romey said.
Asset managers who were “late to the game” are being forced to carve up the markets into ever smaller, more illiquid sectors, said Tom Mench, chairman and chief investment officer of Mench Financial Inc., an advisory firm with $200 million under management.
“It's a troubling trend,” he said. “The liquidity of the ETF is the liquidity of the underlying securities.”
Mr. Donohue conceded that as a result of the financial crisis, “there are any number of things that could get in the way” of his proposal's timely passage. But he has a personal interest in moving it forward.
Currently, the SEC grants ETFs the ability to trade their own shares on a case-by-case basis.
As a result, “in my division, a lot of resources are being taken up by in the exceptive-application area,” Mr. Donohue said.
E-mail David Hoffman at [email protected].
