© Copyright 2018 by K&L Gates LLP. All rights reserved.
Peter J. Shea, New York
Robert L. Sichel, New York
Derek N. Steingarten, New York
January 31, 2018
ETF and Registered Fund
Structuring and Marketing
2018 INVESTMENT MANAGEMENT CONFERENCE
CHICAGO
OVERVIEW OF PRESENTATION
ETF Marketplace - Structuring Developments and Index
Providers
Registered Fund Developments
Distribution Issues, including the DOL Fiduciary Rule
ETF Marketplace - Structuring
Developments and Index Providers
PART I: ETF MARKET DYNAMICS
71 88 106 157 237 314
433 621 542
794 1,012 1,062
1,350
1,701
2,009 2,130
2,550
3,088
95 118 130 134 169 221
381
673
844 925
1099
1370 1445
1536
1661
1845
1971 2044
0
500
1000
1500
2000
2500
0
500
1000
1500
2000
2500
3000
3500
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 17-Aug
U.S. ETP Assets & Number of ETPs by Year # of ETPs Assets ($bn)
DEFINITIONS ARE IMPORTANT: ETFs
ETVs – exchange-listed equity securities
ETVs: Generic term
ETPs: Commodity funds, currency funds
ETFs: Registered funds
Not ETNs - Unsecured, debt securities
Not ETMFs
Mutual funds that trade on exchange
Intra-day pricing at premium/discount to end-of-day NAV
HOW DO ETFs WORK?
Primary Market Secondary Market
Private
Investors
Brokers
Stock Exchange
Au
tho
rize
d P
artic
ipa
nts
ETF
Subscription in kind – The AP delivers a basket of
securities and the ETF issues a unit of
shares
Buy / Sell
Order
Redemption in kind –
The AP delivers a unit of ETF
shares and the ETF pays the
redemption proceeds with a
basket of securities
Bid/offer
Price
Secondary Market Primary Market
Securities
Hedging –Futures/
ETFs
HOW DO ETFs WORK?
Authorized Participants purchase and redeem
Creation Units in-kind in exchange for the
“Creation Basket”
Pro rata slice requirement
Custom Baskets
Authorized Participants (who purchase Creation
Units) sell individual ETF shares on the stock
exchange
ETF Strategies
ETF strategies available:
Index ETFs – Passive Investing
“Smart beta” (bespoke index) ETFs – Factors,
Committees & Artificial Intelligence
Fully transparent actively managed ETFs
ETF strategies pending:
Periodically-Disclosed Active ETFs
Verified iNAV-only Active ETFs
Crypto Currency ETFs & ETPs
8
PART II: BOARD OVERSIGHT OF ETFs
Overview
Market Entry
Regulatory/Structural Obligations
Ongoing Reporting and Oversight
9
MARKET ENTRY ISSUES – ETF BOARDS
Issues for Index ETFs
Market saturation & Intense fee competition
Affiliated index provider
Additional issues for “smart beta” ETFs
Costs
Issues for fully transparent active ETFs
Portfolio transparency
Mutual fund cannibalization
Capacity constraints – Closing Offering & Strategy
Drift
10
REGULATORY/STRUCTURAL OBLIGATIONS
Exemptive order conditions Representations & Ongoing conditions
Stock exchange listing standards
Initial & Continuing
Contracts and service providers
Advisory, sub-advisory and distribution relationships
Index licensing
Cannibalization
11
ONGOING REPORTING AND OVERSIGHT
Specialized Reporting
Index tracking error and correlation
Bid-Ask spreads and trading volume
NAV premium/discount
Custom baskets; in-kind redemptions
Importance of ETF Distribution
Number of APs and market makers
Trading volumes
12
PART III INDUSTRY EXPECTATIONS – NEW
DEVELOPMENTS
Continuing Listing Standards
Custom Baskets
ETF Risk
“True” Active ETFs
Liquidity Risk Rule for ETFs
13
CONTINUING LISTING STANDARDS
Effective for NYSE ARCA, Cboe and NASDAQ
on January 1, 2018
Big impact on index ETFs
Regulation of index providers
Exchanges interpret their own rules
Active ETFs vs. Index ETFs
ETF portfolio liquidity
Index component liquidity
14
CUSTOM BASKET
Used to benefit ETF shareholders: tax
harvesting, portfolio management efficiencies,
etc.
Since 2012, SEC Restriction: Proportionate
Share of Portfolio with very limited exceptions
Tilted Playing Field
Solutions?
ETF RULE
Time is Ripe – Commission Staffing & Priorities
Level the Playing Field
“TRUE” ACTIVE ETFs
Semi-Transparent or Periodically-Disclosed Proxy Portfolios
NAV & iNAV - only
Semi-Transparent Active ETF Hallmarks
Transparency substitute
Tax-efficiency
Arbitrage & Actual Portfolio Replication
LIQUIDITY RULE - IMPACT ON ETFs
Liquidity Risk Management Program for ETFs
Assess, manage and review liquidity risk using ETF-related
factors
Assign 1of 4 “days-to-cash” buckets to each investment
Establish a highly liquid investment minimum
Stay below 15% limitation on illiquid investments
Provide disclosures on N-1A, N-PORT, N-CEN, N-LIQUID
Exception = “In-Kind ETF”
Using more than de minimis amount of cash to meet
redemptions disqualifies designation as In-Kind ETF
Liquidity Risk Management Program required with carveouts
No requirement to assign investments to 1 of 4 “days-to-cash”
buckets
No requirement of highly liquid investment minimum
Must report designation as an In-Kind ETF on Form N-CEN
18
Registered Fund Developments
SIGNIFICANT CURRENT TOPICS FOR
REGISTERED FUNDS
Fund Board Responsibilities
October 2017 IDC Letter to SEC Investment
Management Division
Valuation matters
remain an SEC priority in enforcement and
examination
Fund distribution structure
Oversight of intermediaries and distribution payments
Share classes
SIGNIFICANT CURRENT TOPICS FOR
REGISTERED FUNDS
Liquidity risk management
Compliance December 2018; ICI requested a delay.
Managers may consider alternative approaches to
some asset classes (e.g., closed-end/interval funds?)
Fund investments in Cryptocurrencies
January 2018 SEC Division of Investment
Management letters re. valuation, liquidity, custody
and market manipulation concerns
Risks to new funds proposing to focus on crypto
SIGNIFICANT CURRENT TOPICS FOR
REGISTERED FUNDS October 2017 Treasury Report
Critical of liquidity rule adopted by the SEC in 2016
“mandates an overly prescriptive asset classification or bucketing
methodology” instead of a “principles-based approach” to liquidity risk
Encourages SEC to review interval fund rules
Greater investment in private companies by registered funds, including
shares with limited or no liquidity (e.g., rather than requiring periodic
repurchase offers, SEC should consider allowing redemptions based on a
liquidity event of an underlying holding)
Recommends SEC adopt a rule permitting the operation of “plain
vanilla” ETFs without requiring SEC exemptive relief
Distribution Issues:
DOL Fiduciary Rule
BACKGROUND
Ultimate fate of the rule remains uncertain, but
parts of the rule are effective today
In-scope clients:
• Defined contribution plans
• Defined benefit plans
• IRAs
• HSAs
• Some 403(b)s
• Taft-Hartleys
Over $18T in assets
Over $18T in assets
WHAT ARE THE IMPLICATIONS?
The rule dramatically expands the
circumstances when a party that does not
exercise discretion is deemed to be a fiduciary
As a result, distributors and sponsors may
become ERISA fiduciaries in connection with
distribution activities, even when interacting with
an intermediary, such as a platform provider
If this were to happen, a violation of ERISA could
occur
FIDUCIARY RULE DISTRIBUTION OVERVIEW
If yes, is an exclusion or exemption available?
Independent fiduciary (institutional)
BIC Exemption (retail)
If yes, has a “recommendation” been provided?
“Hire me” concept
Investment education
General communication
Platform providers
Is the prospective client in scope?
IRAs Corporate defined contribution plan
Corporate defined benefit plan
Questions?
