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BlackRock ETFs Face SEC Hurdle in Push for $7.5 Trillion Market

U.S. Securities and Exchange Commission director of the Division of Investment Management Andrew Donohue. Photographer: Brendan Hoffman/Bloomberg
U.S. Securities and Exchange Commission director of the Division of Investment Management Andrew Donohue. Photographer: Brendan Hoffman/Bloomberg

June 24 (Bloomberg) -- Plans by BlackRock Inc. and Vanguard Group Inc. for a new type of exchange-traded fund to challenge actively managed mutual funds may run into opposition from the U.S. Securities and Exchange Commission.

The firms are seeking approval for actively run ETFs -- where managers select holdings -- that would keep some of their assets undisclosed, allowing them to compete better for the $7.5 trillion managed by stock and bond pickers. Unlike mutual funds, which reveal holdings every quarter, ETFs are currently required to disclose assets daily, inviting rivals to copy trades and making it harder for firms to enlist top managers, said Thomas Graves, an analyst with Standard & Poor’s in New York.

“This is more than simply working out the details of a complex product,” said Andrew Donohue, head of the SEC’s investment-management arm, in an interview from Washington. “I’m concerned that the lack of transparency will disrupt the process that keeps a fund’s per-share net asset value and share price closely aligned.”

Since they were introduced in 1993, ETFs in the U.S. have taken almost half of the $1.75 trillion market for so-called passive products, which replicate the composition of a stock or bond index and don’t depend on managers to pick assets. The products, attractive for investors because they’re cheaper and easier to trade, hold less than 1 percent of the market for actively managed funds, which is more than four times as big.

‘High-Profile Managers’

New York-based BlackRock, with $3.36 trillion under management, became the world’s largest asset manager and the biggest manager of exchange-traded funds with the acquisition of Barclays Global Investors on Dec. 1. Vanguard, based in Valley Forge, Pennsylvania, is the third-biggest ETF provider in the U.S., after State Street Corp. Claymore Advisors, a unit of Chicago-based Guggenheim Partners LLC, and ETF Consultants LLC in Summit, New Jersey, also have applications pending for the new ETFs.

“If they’re not allowed to have limited or no transparency, that will keep high-profile fund managers from entering the ETF universe and slow down the potential growth rate,” said S&P’s Graves.

Christine Hudacko, a spokeswoman for BlackRock’s iShares ETF unit in San Francisco, and Rebecca Katz, a Vanguard spokeswoman, declined to comment. Gary Gastineau, managing director at ETF Consultants, said he’s optimistic the SEC will eventually approve the funds.

Unlike mutual funds, ETFs are listed on an exchange, giving investors the ability to buy or sell them throughout the day like stocks. They’re also cheaper, because they don’t have to keep detailed accounting records for every shareholder.

Cost Savings

The average expense ratio for U.S. ETFs in 2009 was 0.57 percent of assets, compared with 0.99 percent for index mutual funds and 1.41 percent for stock mutual funds, data from Chicago-based Morningstar Inc. show.

While those advantages helped ETFs attract assets faster than mutual funds, their growth was driven mainly by index products. In the year ended April 30, U.S. ETF assets rose 57 percent, compared with 41 percent for stock and bond mutual funds, according to the Investment Company Institute, a Washington-based trade group.

Actively run ETFs have largely failed to benefit from those flows. Pacific Investment Management Co. in Newport Beach, California, and six other providers have started 26 such ETFs, according to, a Decatur, Georgia-based website that tracks the industry. The funds attracted a combined $2.38 billion as of June 18, about a quarter of 1 percent of U.S. ETF assets.

‘Huge Opportunity’

Allowing funds to disclose less may help firms attract more assets if it clears the path for star mutual-fund managers to offer ETF versions of their funds, said Tony Baker, a managing director at stock-exchange operator NYSE Euronext.

“This is a potentially groundbreaking product,” William Belden, Claymore’s managing director for ETFs, said in a telephone interview. “It’s a huge opportunity.”

The concerns of the SEC relate to the mechanism that allows ETFs to adjust their prices with their net asset value, or NAV, said Donohue.

When an ETF’s price rises above the NAV of its underlying securities, institutional market makers swap blocks of those holdings, known as creation units, for shares of the fund. The shares are priced at NAV, not market value. The market maker then earns an arbitrage profit when it sells the ETF shares at market value, and the transactions help push the share price and NAV back together. The process is reversed if the ETF trades at a discount to NAV.

Pimco’s Strategy

For the process to work, the ETF must tell market makers what securities to include in the creation unit, inviting two potential problems for funds. For one, managers can take days to move into or out of large positions. If other investors detect that movement, they can jump ahead of the manager and benefit from resulting price changes, a tactic known as front-running.

Followers can also mimic a fund’s trades without paying the management fee. Many mutual funds disclose their holdings only when required, quarterly after a 30-day lag, to prevent others from copying their trades.

Those concerns didn’t stop Pimco from opening three actively managed fixed-income ETFs in the last eight months. Don Suskind, head of ETF products, said the funds won’t draw front-running because they operate in such liquid markets that managers can move into and out of positions within a day. The funds also often buy directly from the issuer, taking most or all of the bonds sold, so it’s difficult to match the holdings at the same price, he said.


AdvisorShares Investments LLC, a Bethesda, Maryland, firm that helps smaller fund companies create and sell actively managed ETFs, opened the fully transparent $22 million Dent Tactical ETF in September with financial forecaster Harry Dent and may start two more actively managed ETFs this year.

Without knowing when a manager will stop buying or selling, a front-running investor can lose money when the strategy is ill-timed, said Noah Hamman, AdvisorShares’ chief executive officer. Copying trades isn’t worth the savings in fees because investors would have to track the fund’s holdings daily, with no guarantee of getting the same price, he said.

Still, top-performing fund managers may be reluctant to disclose their investments daily.

“If I told my fund managers they’d have to disclose all of their portfolio holdings every day, I wouldn’t have many fund managers left,” Bridget Macaskill, president and chief executive officer of New York-based money manager First Eagle Investment Management LLC, said May 6 at a conference in Washington organized by the ICI.

‘Proxy Portfolio’

Vanguard in 2007 proposed a fund of inflation-protected Treasuries that would use a “computer-implemented method” to produce a creation unit matching the yields and other characteristics of its holdings while revealing only 40 percent to 75 percent of the securities, according to a patent application filed by the company.

The fund, like the other applicants, is awaiting SEC action.

Claymore, in its April 2008 submission to the SEC, proposed scrapping the creation unit and publishing a “proxy portfolio” that would reveal some holdings while reproducing the full lineup’s “risk characteristics,” Belden said. Market makers, guided by the proxy portfolio, would buy or sell blocks of ETF shares mostly in cash, he said.

ETF Consultants has proposed a fund that also uses a mechanism to obscure its full holdings. Gastineau said the SEC may come around, as it did with the first U.S. registered ETF, State Street’s SPDR S&P 500 ETF Trust.


“It took the SEC four years to approve the ‘Spider’ because they weren’t convinced that it would work,” Gastineau said. Seventeen years later, the ETF, which tracks the U.S. stock-market benchmark, is the largest exchange-traded fund, with $78.3 billion in assets.

Others say the agency may never assent.

“They have no incentive to approve them and already have some concerns,” said Dave Nadig, director of research for Index Publication LLC, publisher of the Journal of Indexes, said in an interview.

To contact the reporter on this story: Christopher Condon in Boston at

To contact the editor responsible for this story: Christian Baumgaertel at

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