Fund companies looking for regulator permission to include derivatives in active ETFs will no longer have the Securities and Exchange Commission standing in their way—in the first tangible outcome of an SEC review of derivatives use in mutual funds and ETFs that began in March 2010.
The commission didn’t say it was lifting the moratorium on new leveraged and inverse funds, but the ruling that will allow derivatives in active funds could have a quick effect on popular active ETFs such as Bill Gross’ $3.83 billion Pimco Total Return ETF (BOND) that can’t currently make use of derivatives.
“Although the Division continues its ongoing review of the use of derivatives by funds, Division staff will no longer defer consideration of exemptive requests under the Investment Company Act relating to actively managed ETFs that make use of derivatives,” Norm Champ, the Director of the SEC’s Division of Investment Management, said today in prepared remarks during a conference in New York.
While Champ didn’t officially close the inquiry, he framed the question of the SEC’s position on leverage and inverse funds in such a manner as to suggest that perhaps those firms hoping to get a piece of a business dominated by Bethesda, Md.-based ProShares and Newton, Mass.-based Direxion ought not hold their breath for an SEC change of heart.
“Because of concerns regarding leveraged ETFs, however, we continue not to support new exemptive relief for such ETFs,” Champ said.
That’s important because derivatives use in leveraged and inverse funds “were at the root of the moratorium originally,” said Kathleen Moriarity, a New York-based securities lawyer with Katten Muchin Rosenman LLP who has written countless ETF prospectuses, including the one for the first U.S. fund, the now $110 billion SPDR S'P 500 ETF (SPY).
Marquee Managers To Benefit
Moreover, the ruling won’t necessarily change the difficulty active ETFs are having in gaining market share, but it will help fund companies with brand-name managers like Gross gain a measure of flexibility in how they run their active portfolios in an ETF wrapper.
“The lifting of the ban on active management isn't likely to be a floodgate,” said Dave Nadig, Director of Research at IndexUniverse in an interview.
“The real deal in active management would be the entry of traditional players with 'brand track record' that could make up for a lack of a real track record,” Nadig added, noting however that the ban on derivatives hasn’t really discouraged huge players like Fidelity from rolling out funds.
"I don't think the active ban has kept anyone from ETFs. The transparency of ETFs and fee erosion has,” he said, adding that the lifting of the band may well encourage existing active ETFs to use simple derivatives such as futures to equitize small portions of their portfolios for tracking purposes.
He also noted that the fact that the SEC continues to balk at the idea of approving new funds that use derivatives in leveraged and inverse funds isn’t a big deal as the pocket is already inhabited and pretty much covered by ProShares, Direxion and iPath, the exchange-traded note firm backed by UK-based Barclays Plc.
The SEC review applied to actively managed and leveraged ETFs, particularly those that plan to use swaps and other derivative instruments to achieve investment objectives.
It never affected firms that already had permission to use derivatives, much to the frustration of ETF sponsors who felt they were caught in the wrong place at the wrong time.
Specifically, the SEC inquiry precluded the approval of any pending or planned “exemptive relief” petition seeking permission to market funds making use of derivatives.
Exemptive relief grants ETF firms exception to sections of the Investment Act of 1940 and is just the first step in the path to launching ETFs.
It often takes at least six to 12 months from the date of the initial filing for a company’s first ETF to hit the market, though the SEC inquiry has left petitions languishing at the commission for more than 2 1/2 years.
Champ’s speech was at the ALI CLE 2012 Conference on Investment Adviser Regulation today in New York.
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