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SEC Lifts Restriction on Active ETFs’ Derivativates Use

The U.S. Securities and Exchange Commission cleared one obstacle for exchange-traded funds that try to beat benchmarks by lifting a ban on the funds’ use of derivatives.

Proposed funds will have to meet requirements on managing risk and disclosure, Norm Champ, director of the division of investment management, said yesterday in a speech at a New York conference for investment advisers. The agency still won’t approve new ETFs that use derivatives to amplify returns or provide the inverse performance of an index.

Active ETFs seek to combine the skill of a manager selecting investments with the trading flexibility, lower fees and tax advantages of ETFs, which typically track an index. An ETF version of Bill Gross’s Pimco Total Return Bond Fund, the world’s largest mutual fund, has grown to $3.8 billion since its introduction in February, making it one of the 15 biggest bond ETFs in the U.S.

“It is a step forward,” said Christine Hudacko, a spokeswoman for BlackRock Inc. (BLK), the largest ETF provider.

BlackRock, based in New York, and Atlanta-based Invesco Ltd. (IVZ) are among companies with pending requests to introduce actively managed ETFs.

ETFs hold baskets of securities, commodities or other assets while trading throughout the day like individual stocks. Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.

‘Deliberate Approach’

The SEC froze approval for new ETFs that make significant use of derivatives in March 2010, seven months after warning that some products could confuse individual investors. Champ said the SEC will continue to review the use of derivatives by funds.

“Given the complexity and significance of the issues relating to funds’ use of derivatives, both for the fund industry and for the protection of investors, we are taking a deliberate approach in our continuing review,” he said.

Gross, co-chief investment officer at Pacific Investment Management Co. in Newport Beach, California, uses a combination of options, futures and swap agreements, for his flagship mutual fund. The tools have been prohibited for the ETF. Pimco said in a filing last year it would use derivatives in the ETF if the SEC should lift the ban.

Pimco Total Return ETF (BOND) has returned 12 percent since inception, compared with 7.4 percent for Gross’s mutual fund.

Almost all ETFs track indexes tied to benchmarks, appealing to investors because of their trading flexibility and lower costs. Actively managed ETFs in the U.S. oversee about $10.3 billion, or about 0.8 percent of the industry total, according to data compiled by Bloomberg and Morningstar Inc. (MORN)

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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