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SEC Guidance Expected for Exchange Funds

Washington, D.C. - The possibility that actively-managed exchange-traded funds could cause market volatility is one of the issues to be addressed in a concept release' that the Securities and Exchange Commission expects to issue in the next few months, according to Paul Roye, director of the SEC's division of investment management. Roye discussed the SEC's active exchange-traded fund concept release at the general meeting of the Investment Company Institute of Washington D.C. here earlier this month.

The main problem an actively-managed exchange-traded fund presents is how to keep the market price close to the fund's net asset value without requiring the fund to release its holdings daily, according to Christopher Traulsen, an analyst at Morningstar of Chicago. If a fund is required to disclose its portfolio, there is little to prevent front running, he said. With passive exchange-traded funds, disclosure is not a problem since the securities that make up the index are already public knowledge.

"We want to get input on various views and potential consequences," said Roye, following his speech. "How can they work? With an active ETF, how do you achieve transparency like with an index fund? How will you prevent front running? What we'd like to do is ask as many questions and raise as many issues as is possible."

Would active exchange-traded funds contribute to market volatility?' is one question that might be asked in the concept release, according to Roye.

"We're looking into that question," said John Heine, an SEC spokesperson. "We haven't come to any conclusions between ETFs and market volatility. That's a fairly complicated subject."

There are several scenarios in which an actively-managed exchange-traded fund could cause increased volatility in the marketplace, according to analysts. Under one scenario, there might be no way of avoiding the movement of actual securities when active exchange-traded fund shares are bought and sold as there is now with passive exchange-traded funds, according to Ramy Shaalan, a mutual fund analyst with Wiesenberger/Thomson Financial of Rockville, Md. With passive exchange-traded funds, shares correspond to certain specified stocks. Warehouse receipts for those stocks exist in a bank and are traded back and forth without causing the buying and selling of the actual stocks those receipts represent, according to Shaalan.

"With an actively-managed ETF, there's not going to be a fixed amount of stocks in the bank," said Shaalan. "It's going to go back and forth because it's an actively-managed ETF and that's where the volatility comes. You're going to unwillingly have to move stocks when shares are traded. They haven't figured out how to do it in such a way where you don't really have to change the mixture of these stocks."

Because of that, one possibility that has been discussed for active exchange-traded funds is not using the warehouse receipt mechanism used for passive exchange-traded funds but implementing an entirely different system, according to Shaalan. That is one proposal that might come out of the concept release, he said. Another scenario in which active exchange-traded funds might cause market volatility is as a result of front running, according to Traulsen. There does not appear to be a method of keeping the market price close to the net asset value of the fund without disclosing the holdings of the fund frequently, he said. Current index-based exchange-traded funds disclose their holdings daily.

"If this inspires people to front run active ETFs left and right, it could impart volatility to the market," said Traulsen. "If these things really took off and became a large part of the market, it would be like if a fund as big as some of those Fidelity funds was out there announcing its holdings everyday. People might be turning on a dime watching what they're doing and I could see where that could impart a lot of extra volatility into the market."

This is especially true of larger funds, according to Traulsen. A small fund buying the blocks of securities it needs would not create major problems. That trading would not move the market and people would therefore not benefit from front running, according to Traulsen.