The SEC Says “No!” to Next-Generation ETFs
Thursday, October 23, 2014

The exchange-traded fund (ETF) industry was dealt a setback this week. Two applications for next-generation actively managed ETFs were rejected by the Securities and Exchange Commission (SEC). Both applications (one of which iShares owner BlackRock was involved with) were for several ETFs that would have been actively managed but followed the less transparent mutual fund disclosure rules.

Had the SEC given its blessing, several new investment options in the ETF space would likely have been introduced. These ETFs would have provided direct competition to actively managed mutual funds. Presumably, such funds would have given you and me access to active management at a lower cost.

Instead, the SEC adamantly rejected the applications. The agency called the structure of the proposed ETFs “inherently flawed.” Ouch.

The rejection reinforces the barrier separating ETFs and mutual funds. I’m going to get a bit technical here, but if you’re willing to put up with industry lingo, you'll understand why this week’s rejections are making headlines in the fund industry.

Mutual funds adhere to the Investment Company Act of 1940 (aka, the ’40 Act). For an ETF to come to market, an application for exemptive relief is sought to allow the fund to trade on the secondary markets as opposed to being bought and sold directly from the fund company, as mutual funds are. The SEC has granted exemptive relief if an ETF’s holdings are disclosed daily. This transparency allows market makers to determine what the net asset value (NAV) of an ETF is and continuously adjust the fund’s share price to be close to or at net asset value.

Relatively few actively managed ETFs have to come to market so far because of the transparency rules. Active managers are concerned that if their holdings are updated on a daily basis, other market participants will be able to detect what portfolio changes are occurring and trade ahead of them. This is why the largest actively managed ETFs right now are bond funds, such as PIMCO’s Total Return ETF (BOND). It’s harder to replicate a bond portfolio than it is a stock portfolio.

Precidian ETFs Trust and Spruce ETF Trust (which was working with BlackRock) had sought a workaround. Their applications sought exemptive relief for actively managed ETFs that disclosed holdings on a quarterly basis, with a lag of not more than 60 days. In order to keep the prices from straying away from the ETFs' NAVs, the companies proposed using indicative intraday value (IIV). This value would be disseminated by an exchange every 15 seconds during the trading day and would be calculated from a “daily list of securities constituting the proposed ETF’s portfolio from the ETF sponsor.” If this did not prevent the ETF from trading at a discount to its NAV, individual investors would have the option, based on certain conditions being met, to sell their shares to the ETF sponsor at a 2% redemption fee (plus likely brokerage commissions).

Combined, these characteristics are what the led the SEC to call the structure of the proposed ETFs “inherently flawed.” The agency has required ETFs to have a mechanism to ensure their shares trade at a price that “is at or close to” NAV since the first ETF was approved. Indicative intraday value is viewed as a poor substitute for actual NAV pricing. (The SEC says that both “applicants explicitly disclaim making any warranty by the ETFs as to the accuracy of the IIV.”) This and the proposed lack of transparency regarding the fund’s actual holdings were viewed as leading to situations where individual investors would not be able to transact at NAV prices, while market makers and other large institutional investors could (via creation units—large blocks of ETF shares—bought from and sold to the fund sponsor). The redemption options for protecting individual investors, should the ETFs trade at a discount to NAV, were viewed as being designed in a way that would discourage their use. Finally, the SEC was concerned that “any breakdown in the pricing or the ability to price the proposed ETF may result in damage to market confidence in secondary trading of ETFs—not just in the proposed product, but in ETFs generally.”

The applicants can appeal for a hearing, so the door is not completely shut on these next-generation actively managed ETFs. Given the language used by the SEC, however, the hurdle they face is significantly higher.

The SEC’s rulings for the Spruce ETF Trust, et al.  and the Precidian ETFs Trust, et. al applications are available on its website.

More on AAII.com

AAII Model Portfolio Update

There are two changes to the Model Fund Portfolio. As of October 1, 2014, we removed FMI Common Stock (FMIMX) from the Model Fund Portfolio. Underperformance compared to its high fees were cited, along with the risk of FMI Common Stock being a closed fund.

We are replacing FMIMX with First Trust US IPO (FPX). First Trust US IPO is an exchange-traded fund that tracks an index of larger U.S. initial public offerings. It modifies the capital weighting so that very large capitalized companies do not dominate.

If you are following the Model Fund Portfolio, then all existing holdings, including the new holding, should be equally weighted (nine if you own the closed fund CHTTX, or eight if you don’t). You can accomplish this easily by selling FMI Common Stock fund and putting the proceeds into the First Trust US IPO fund.

If you follow the All-ETF Portfolio, the weights should be changed to adjust for the new ETF holding. The weights are: 20% in FPX, 20% in RSP, 20% in RFV, 20% in RZV, 10% in FM, and 10% VNQ. The Guggenheim S&P 500 Equal Weight fund (RSP) is split from a 40% weighting to a 20% weighting since it is also a large-cap fund. That allows a 20% weighting for the new purchase of FPX. The Guggenheim S&P MidCap 400 Pure Value fund (RFV) and the Guggenheim S&P SmallCap 600 Pure Value fund (RZV) remain at their current weighting of 20% each. The iShares MSCI Frontier 100 fund (FM) and the Vanguard REIT Index fund (VNQ) remain at their existing weighting of 10% each.

James Cloonan provides a more thorough discussion of the changes in the forthcoming November AAII Journal.

As previously mentioned regarding the Model Shadow Stock Portfolio, Medical Action Industries (MDCI) was acquired by Owens & Minor Inc. (OMI) on October 1, 2014, triggering its removal from the portfolio.

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AAII Sentiment Survey

The proportion of individual investors expressing optimism about the short-term direction of the stock market surged to 49.7% in the latest AAII Sentiment Survey. At the same time, pessimism plunged.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped by 7.0 percentage points to 49.7%. This is the highest level of optimism registered by our survey since August 28, 2014 (51.9%). It is also the 10th week out of the past 11 with optimism above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 4.2 percentage points to 27.8%. Even with the increase, neutral sentiment is below its historical average of 30.5% for the fourth week in the past five.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell by 11.2 percentage points to 22.5%. The large drop puts pessimism at its lowest level since August 28, 2014.

As the results to this week’s special question show, many individual investors viewed the recent downward volatility as a buying opportunity. The pullback in the S&P 500 and the correction in the Russell 2000 made valuations more attractive and helped to alleviate concerns about stock prices having moved too far upward too fast. Also contributing to the level of optimism are earnings growth, sustained economic expansion and the Federal Reserve’s tapering of bond purchases. Keeping other AAII members cautious are worries that a larger drop in stock prices is forthcoming, a sense that prevailing valuations are still too high, geopolitical events, the pace of economic growth and Washington politics.

Bullish sentiment has risen by a cumulative 14.3 points over the past three weeks. At current levels, optimism is at an unusually high level (more than one standard deviation above average). Past readings of unusually high optimism have typically been followed by lower-than-average levels of market gains, as I explained in the June 2014 AAII Journal.

This week’s special question asked AAII members how the recent volatility has influenced their willingness to buy stocks. About 44% of respondents said they are either looking to buy, are more willing to buy or have bought. Another 19% said they are anticipating a bigger drop, looking for confirmation of a bottom or are sitting on the sidelines. Roughly 9% said the volatility hasn’t altered their willingness to buy stocks, with many of these respondents saying that they follow long-term strategies. Less than 4% of respondents said they have sold stocks in response to the volatility.

Here is a sampling of the responses:

  • “I have bought some stocks and may buy more.”
  • “I purchased a stock on my ‘shopping list’ because blood appeared on the street.”
  • “Accelerated my efforts to find quality stocks to purchase now that they are ‘on sale.’”
  • “I am waiting for better prices on the stocks I have been monitoring.”
  • “Waiting for the official correction to buy more stocks.”
  • “I wish I had more cash to buy stocks.”


This week’s Sentiment Survey results:

Bullish: 49.7%, up 7.0 points
Neutral: 27.8%, up 4.2 points
Bearish: 22.5%, down 11.2 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!