A PROCESS OF NATURAL CORRECTION: ARBITRAGE AND THE REGULATION OF EXCHANGE-TRADED FUNDS UNDER THE INVESTMENT COMPANY ACT Daniel J. Grimm* I. INTRODUCTION In early 2008, the Securities and Exchange Commission (SEC) issued for the first time exemptive orders permitting fully transparent actively managed exchange-traded funds (ETFs) to list on national stock exchanges,1 with the first listing occurring on March 25, 2008.2 Also in March, the Commission issued proposed rule 6c-11 under the Investment Company Act of 1940 (the “1940 Act” or the “Act”),3 which would exempt * J.D. 2007, Columbia University School of Law. The author is an Associate in the Washington, D.C. office of Sullivan & Cromwell LLP. This Article reflects the views and opinions of the author, which should not be imputed to any other person or entity. This Article does not contain advice of any kind. 1. See, e.g., WisdomTree Trust et al., Order Under Sections 6(c), 12(d)(1)(J) and 17(b) of the Investment Company Act of 1940, Investment Company Act Release No. 28,174, 2008 SEC LEXIS 1360 (Feb. 27, 2008); see also WisdomTree Trust, et al., Notice of Application, Investment Company Act Release No. 28,147, 73 Fed. Reg. 7776 (Feb. 6, 2008) [hereinafter WisdomTree Trust, Notice of Application]. 2. The first actively managed bond ETF, the Bear Stearns Current Yield Fund (YYY) was launched on the American Stock Exchange (AMEX) on March 25, 2008. See Murray Coleman, Bear Stearns Launches First Ever Active ETF, SEEKING ALPHA, March 25, 2008, http://seekingalpha.com/article/69871-bear-stearns-launches-first-ever-active-etf. The fund was liquidated in early October. See Scott Ebner, Bear Stearns Current Yield Fund (Ticker: YYY) to be Liquidated, ETF Notice #08-040, American Stock Exchange, Sept. 29, 2008, http://www.amex.com/amextrader/tdrInfo/data/axNotices/2008/etf08040.pdf. Other actively managed ETFs, including equity-based funds, continue to trade. See, e.g., NYSE Euronext, Press Release, “PowerShares Lists its First Ever Actively-Managed ETFs on NYSE Arca,” Apr. 11, 2008, http://www.nyse.com/press/1207739565764.html. 3. Comments on the Proposed Rules were due May 19, 2008. Exchange-Traded Funds, Investment Company Act Release No. 33-8901, 73 Fed. Reg. 53, at 14,618 (Mar. 18, 2008) (to be codified at 17 C.F.R. pts. 239, 270 and 274) [hereinafter SEC Proposed Rules]. While it is difficult to predict when the SEC is likely to implement the Proposed Rules, some practitioners anticipate “that the likely implementation date for any final rules based 95 96 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1 transparent ETFs—those that track a published securities index or are actively managed with disclosed portfolio holdings—from various requirements of the Act.4 After years of speculation about when the SEC would approve the first actively managed ETFs,5 the first structures acceptable to regulators are more of the same,6 with a twist. While the newly-approved actively managed ETFs increase flexibility by permitting portfolio holdings to detach from published indices, they nonetheless remain fully transparent, much like their index-tracking predecessors.7 As the SEC notes, “an actively managed ETF would operate in the same manner as an index-based ETF,”8 with Intraday Value transmitted every fifteen seconds.9 Daily disclosure of portfolio holdings, a feature emblematic of the traditional equity index structure, also characterizes the new, actively managed ETFs approved by the SEC.10 Still, while the first actively managed ETFs do not free innovators from transparency requirements, the SEC nonetheless indicates that its recent actions do not foreclose the possibility that future structures may operate with less openness. In a comment that could easily encourage a on the Proposed Rules would occur no earlier than the beginning of 2009.” Client Advisory, Katten Muchin Rosenman LLP, SEC Proposes New Rules to Streamline ETF Formation (Mar. 24, 2008), http://www.kattenlaw.com (search “ETF”; then follow article hyperlink). 4. SEC Proposed Rules, supra note 3, at 14,618; see Exchange-Traded Funds, SEC News Dig., Issue 2008-49 (Mar. 12, 2008), http://sec.gov/news/digest/2008/dig031208.htm (explaining further how the proposed rule changes would impact Investment Company Act exemptions applicable to ETFs). 5. See John Authers & Rebecca Knight, Active Solution is Within Reach, FIN. TIMES USA, Jan. 30, 2007, at 1 (“It has been talked about for years, but 2007 might be the year that the first actively managed exchange traded fund makes it to market.”); Diya Gullapalli, Actively Traded ETFs: A Step Closer to Reality, WALL ST. J., Feb. 5, 2008, at C3 (“Regulators appear to be on the verge of approving a highly anticipated new type of exchange-traded fund.”); Chuck Jaffe, Next Generation of ETFs Will Reshape Fund Business, THOMSON FIN. NEWS (Sept. 27, 2006) (Westlaw, Thomsonfin) (“Regulators who have been winking at the new [ETFs] and allowing them to be ‘active’ but not ‘actively managed’ are likely to cross that line in the near future. You can expect actively managed ETFs by year’s end.”). 6. SEC Proposed Rules, supra note 3, at 14,620 n.27 (“[E]ach of the actively managed ETFs operating under the recent exemptive orders approved by the Commission is required to make public each day the securities and other assets in its portfolio.”). 7. Id. at 14,623; see Stacy L. Fuller, The Evolution of Actively Managed Exchange- Traded Funds, REV. SEC. & COMMODITIES REG., Apr. 16, 2008, at 89 (“By the end of 2007, several hundreds of ETFs had been organized—all of them, index-based.”). 8. SEC Proposed Rules, supra note 3, at 14,623. 9. Id. at 14,625 n.95. 10. See Press Release, Foley & Lardner LLP, Foley & Lardner LLP Counsels First Actively-Managed Exchange Traded Fund (Mar. 12, 2008), http://www.foley.com/news/news_detail.aspx?newsid=3408 (discussing how the first actively managed ETF, The Bear Stearns Current Yield Fund (YYY), would report its entire u nderlying portfolio online each day). 2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 97 new round of speculation regarding the next era in the evolution of ETF products, the SEC noted, “[b]y proposing [a rule to permit fully transparent ETFs to register without securing individual exemptive orders] we are not, however, suggesting that we will not consider applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule’s transparency requirements.”11 Prior to recent approvals, the SEC had left actively managed ETFs suspended in regulatory stasis pending the resolution of transparency concerns.12 As reflected in a 2001 concept release, the SEC hesitated to approve actively managed structures because fund managers might sacrifice transparency—“a hallmark of ETFs”13—for stronger market performance.14 Equity index ETFs had always published daily the securities needed to acquire shares from funds, as well as the securities tendered to investors when creation units were redeemed.15 Andrew Donohue, Director of the SEC’s Division of Investment Management, explained that the Commission feared fund managers would act to prevent “too much transparency,”16 a move perceived as dangerous, particularly in a shifting market environment where increasing numbers of retail investors are trading ETF shares.17 In approving the first actively managed ETFs, the SEC, rather than overcoming its concerns with transparency, simply limited current approvals to transparent structures. As a result, while active management represents a new evolution in the ETF industry, newly- approved funds remain firmly anchored—at least for now—to the same principles that underlie previous approvals of equity index ETFs. This Article does not attempt to predict whether or when the SEC will approve an actively managed ETF that does not conform to current transparency requirements, but instead takes a backward glance at the regulatory approval process, with the view that a look back may reveal significant information about the future. As curious investment structures 11. SEC Proposed Rules, supra note 3, at 14,623. 12. See Andrew J. Donohue, Dir., Div. of Inv. Mgmt., Sec. & Exch. Comm’n, Speech by SEC Staff: Remarks Before the 4th Annual Art of Indexing Summit (Sept. 20, 2006), http://www.sec.gov/news/speech/2006/spch092006ajd.htm. 13. Id. 14. Id. 15. See, e.g., 1 Reg. of Inv. Companies (MB) § 26.02[1][a] (2008) (describing transparency in ETF formation and operation). 16. Donohue, supra note 12. 17. See, e.g., Rebecca Knight, Irresistible Rise of the Flexible Fund, FIN. TIMES USA, Jan. 10, 2006, at 10 (reporting that two-thirds of a major U.S. bank’s ETF trades have come from retail investors); see also Lawrence C. Strauss, New Frontier: ETFs Are Surging in Popularity. Get Ready for Actively Managed Versions. (Exchange-Traded Funds), BARRON’S, Jan. 3, 2005, at F5 (noting ETFs are popular with both retail and institutional investors). 98 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1 that traverse the line between open-end18 and closed-end19 funds, ETFs already have raised numerous regulatory headaches underscored by unspoken normative judgments, some of which can be extracted from a web of exemption letters and statutory language. If there is an element common to ETF approvals, it is that all are based on a delicate regulatory surgery performed under the Investment Company Act of 1940.20 Rather than strike directly at the issue of active management, this Article seeks to distill the underlying assumptions, goals, and regulatory values that inform the history of exemptive relief under the Investment Company Act for equity index ETFs and, now, actively managed, transparent ETFs. The Article concludes that the common principles behind various exemptions unite to support a general theory of how regulators believe the ETF market should function. Transparency, at both the index and the portfolio level, has been the cornerstone of exemptive relief from various provisions of the Act, because it fosters an arbitrage mechanism that protects retail investors by creating price effects that ripple through the secondary market and push trading prices toward net asset value (NAV).21 Embedded within regulatory deference to the ETF arbitrage system is the SEC’s implicit recognition that the natural corrective abilities of a liquid and transparent market often protect investors more effectively than regulatory mandates. This Article takes the position that an arbitrage-driven price stability regime is the central reason why index-tracking and transparent actively managed ETFs have received exemptive relief from various constraints imposed by the Investment Company Act.22 18. The Investment Company Act defines an open-end company as “a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.” 15 U.S.C. § 80a-5(a)(1) (2000). 19. See, e.g., 15 U.S.C. § 80a-5(a)(2) (2000) (defining a closed-end investment company under the Investment Company Act as simply “any management company other than an open-end company”); see also SEC, Closed-End Funds, Answers Page, http://www.sec.gov/answers/mfclose.htm (last visited Oct. 16, 2008) (explaining that closed-end funds typically offer a fixed number of shares in an initial public offering and later trade on secondary exchanges). Shares in closed-end funds usually are not redeemable, such that closed-end funds are not subject to the same liquidity requirements as open-end funds. Id. 20. As Stacy L. Fuller explains, exemptive relief from the Investment Company Act requires that regulators deviate from the letter of the statute: “While the 1940 Act provides clear and divergent regulatory regimes for open- and closed-end funds, it does not provide a regime for open- and closed-end hybrids, such as ETFs. The SEC plays an important role in filling that vacuum, by using its exemptive powers to create a regulatory regime for ETFs.” Fuller, supra note 7, at 91. 21. See infra Part II.D (discussing transparency and the arbitrage system). 22. The proposition that arbitrage has informed exemptive relief for ETFs is not a controversial one. In its Proposed Rules, the SEC requested comment on the following q uestion: “Does the requirement that an ETF establish creation unit sizes the number of 2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 99 If an efficient arbitrage mechanism is critical to investor protection, and if arbitrageurs require transparency to perform their stabilizing function, then what is to be said of non-transparent actively managed ETFs? Some commentators focus on the risk of front-running,23 and how it may raise concerns about openness by fund managers.24 Depending on the financial innovations underway to counteract this situation, actively managed ETFs may indeed provide investors with less transparency than the index-tracking variety.25 Nonetheless, this Article does not predict whether the SEC will eventually approve non-transparent actively managed ETFs, but instead aims to shed light on why the SEC has approved the existing class of transparent funds. By subjecting the evolution of SEC approval of transparent ETFs to the harsh gaze of hindsight, this Article intends to help clear a path for future structures by navigating the often- tangled maze of values that has produced the first two generations of ETF products. II. FINANCIAL STRUCTURE A. The Indexing Tradition Despite the SEC’s recent approval of actively managed ETFs, most existing ETFs remain passive26 instruments that track an underlying securities index,27 such that the portfolio changes only in response to a which is reasonably designed to facilitate arbitrage provide the sponsor or advisor of the ETF with sufficient guidance in setting appropriate thresholds?” SEC Proposed Rules, supra note 3, at 14,627. This Article seeks to advance the discussion of the role arbitrage plays in the regulation of ETFs, by exploring the nuances and specific justifications behind its importance in the regulatory setting. 23. See Thao Hua, Bear Stearns Could Land 1st Active ETF on U.S. Shores, PENSIONS & INVESTMENTS, Apr. 30, 2007 (noting that transparency is one of the biggest challenges facing actively managed ETFs, because managers must fully disclose the underlying portfolio and run the risk that other managers may front-run their strategies); Raquel Pichardo, Solving Puzzle of Active ETFs, PENSIONS & INVESTMENTS, Oct. 1, 2007 (explaining that transparency is the most daunting regulatory hurdle facing fund managers who are trying to launch the next wave of ETFs, because “[m]anagers worry that full transparency of their trades will betray their investment processes and open the door to front-runners”). 24. Pichardo, supra note 23. 25. See sources cited in supra note 23 (discussing risks of transparency to fund managers). 26. Here, “passive” indicates a lack of active trading by fund managers. 27. See e.g., SEC, Exchange-Traded Funds (ETFs), http://www.sec.gov/answers/etf.htm (last visited Oct. 23, 2008) (noting, in 2007, that “all ETFs seek to achieve the same return as a particular market indexes [sic]”). 100 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1 change in the index.28 Equity index ETFs “closely mirror” their underlying indices, making portfolio turnover rare.29 Traditional securities indices30 typically include equities based on capitalization weighting,31 which is partially explained by the relationship between high capitalization and liquidity.32 Early ETFs strove to replicate the performance of traditional stock indices such as the Dow Jones Industrial Average and the S&P 500 Index.33 Before actively managed structures emerged, the ETF industry began to develop new indices for the purpose of launching equity index ETFs.34 Fueled by the growing popularity of ETFs as investment vehicles, sector- specific and fund-specific indices have produced increasingly narrow benchmarks.35 The demand for increasingly diverse offerings has created a situation where “more indices are being developed to form the basis of new ETFs,”36 marking a change from the time when ETFs were built around then-existing, traditional indices.37 While “fund-friendly” indices may use the same capitalization method of traditional benchmark indices, they differ 28. See Anthony Ragozino & Charlie J. Gambino, Actively-Managed Exchange Traded Funds: Coming Soon to a Market Near You? 8 INVESTMENT LAWYER 3 (2001) (explaining that an ETF is designed to track a particular stock index, such that the ETF’s portfolio changes only if the benchmark index changes). 29. Vipul K. Bansal & Archana Somani, Exchange Traded Funds: Challenge to Traditional Mutual Funds, REV. OF BUS., Fall 2002, at 41. 30. Indices such as the Dow Jones Industrial Average, the S&P 500 Index, and the NASDAQ Composite Index were not “originally created with the idea that a fund portfolio replicating the structures and rules of the index would be a popular investment. These indexes were developed to serve as market indicators and/or as a standard for comparison with actual portfolios managed by active portfolio managers.” GARY L. GASTINEAU, THE EXCHANGE-TRADED FUNDS MANUAL 131 (John Wiley & Sons, Inc. 2002). 31. See, e.g., id. at 131 (noting that, with the exception of the original Dow Jones Industrial Average and the Nikkei Average, most popular indices are capitalization weighted). 32. See id. at 132 (correlating market capitalization and liquidity). 33. See, e.g., Diya Gullapalli, Why Hot Funds are Tripping Up Some Investors–ETFs, Which are Meant to Track Benchmarks, Increasingly Go Astray, WALL ST. J., Apr. 19, 2007, at A1 (explaining that ETFs “were designed to match the performances of various market benchmarks, such as the Standard & Poor’s 500-stock index”). 34. See GASTINAEU, supra note 30, at 132-33 (discussing reasons for the development of new indices that depart from the capitalization weighted approach); see also SEC Proposed Rules, supra note 3, at 14,619 (explaining that many newer ETFs are based on more specialized indices, including some designed specifically for a particular ETF). 35. Exchange Traded Funds Growing in Popularity, INVESTMENT ADVISER, June 4, 2007, http://www.ftadviser.com (search “Exchange Traded Funds Growing in Popularity”; then follow article hyperlink). 36. Id. 37. See, e.g., Authers & Knight, supra note 5, at 11 (observing that while ETFs traditionally were based on conventional indices and weighted by market capitalization, ETF providers recently have launched funds that incorporate alternative weighting strategies). 2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 101 by considering “the structural requirements of funds, the economics of trading, the investment objectives of funds, and the presence of other investors in the marketplace.”38 Others use alternative weighting methodologies39 that depart from capitalization weighting to incorporate factors such as cash flow, dividends, sales, and book value.40 Sampling strategies, in which ETFs track a limited array of securities from a given index based on a wide array of selection strategies, are also common.41 For example, the benchmark index might be limited to securities that come out favorably in a dividend weighting evaluation.42 These new indices “convert an established stock selection process into an index which serves as the template for a portfolio.”43 Unsurprisingly, given the demand for increasingly specialized sector exposure, recently-developed indices have led to ETFs “of virtually every flavor,”44 including those that track private equity, gold, vaccines, intellectual property, nanotechnology, and renewable energy.45 Demand for greater sector exposure has also led to commodities ETFs that, unlike mutual funds that hold equity in publicly- traded commodities companies, attempt to track the prices of the underlying commodities themselves, typically through direct ownership or futures contracts.46 38. GASTINAEU, supra note 30, at 132. 39. Authers & Knight, supra note 5, at 11. 40. ETFs Growing in Popularity, supra note 35; see also Rob Carrick, The Case for Blending Passive, Active Indexing, GLOBE & MAIL UPDATE, May 19, 2007 (describing the new paradigm of fundamental indexing as a refinement of traditional indexing). 41. See Paul F. Roye, Dir., Div. of Inv. Mgmt., SEC, Speech by SEC Staff: Regulatory Issues Involving Exchange Traded Funds at the American Stock Exchange Symposium on Exchange Traded Funds, (Jan. 14, 2002), http://www.sec.gov/news/speech/spch534.htm (explaining that “rather than holding securities that replicate an entire index, [an ETF] could instead use ‘sampling techniques’ to track the performance of an index . . . . By ‘sampling’ the stocks in an index, the exchange traded fund can seek to replicate the performance of the index without actually owning all the component stocks in the index.”). 42. See, e.g., Rob Garver, The ETF Evolution, BANK INV. CONSULTANT, Mar. 2007, at 25 (citing ETFs issued by WisdomTree Investments as an example). 43. GASTINAEU, supra note 30, at 165. 44. Chuck Jaffe, ETFs v. Mutual Funds: Winner Depends on You, THOMSON FIN. NEWS, July 30, 2006. 45. Revolution or Pollution? Exchange-Traded Funds, ECONOMIST, Apr. 21, 2007, at 83-84; see David E. Stout & Huaiyu Chen, A Primer on Exchange Traded Funds: Purpose, Operation, and Risk, THE CPA J., Sept. 2006, at 56 (commenting that the list of ETFs is comprehensive enough that today’s investors “can use ETFs to cover all the sectors, styles, and market capitalization options associated with ordinary mutual fund investments”). 46. See, e.g., Philip McBride Johnson, The CFTC and Commodity-Based Exchange- Traded Funds, 11 DERIVATIVES USE, TRADING & REG. 303, 304 (2006) (noting that ETFs commonly are tied in value to the price of gold or other commodities trading on a futures exchange); see also Robert S. Bernstein, Oil, Currency, and Silver Commodities Come to the Securities Market, 33(4) CORP. TAXATION 40 (2006) (noting the emergence of commodity-based ETFs). 102 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1 B. Actively Managed, Transparent ETFs The new structures that the SEC approved in early 2008 differ from their predecessors in that fund managers are no longer bound by the confines of a particular securities index. Nevertheless, all actively managed ETFs approved by the SEC must disclose their portfolio holdings daily, just like the traditional index-tracking variety that preceded them.47 The commonality between the first actively managed ETFs and traditional equity index ETFs is that both are “fully transparent.”48 The first generation of actively managed ETFs provides disclosure in largely the same manner as index-tracking funds49 with the main difference concerning an enhanced freedom to select and trade portfolio securities. While ETF fund managers are no longer confined to a particular index, the SEC nonetheless limits its approval “to transparent actively managed ETFs,”50 which must fully disclose their holdings.51 All existing ETFs may therefore be characterized as transparent. C. Creation and Redemption In most cases, an authorized participant52 creates an ETF by depositing a block of securities, called a portfolio deposit,53 with a custodian in exchange for shares of equivalent value.54 The authorized participant receives from the ETF sponsor a block of shares called a 47. See WisdomTree Trust, Notice of Application, supra note 1, at 7780 (“On each Business Day, before the commencement of trading in Shares on the Fund’s listing Exchange, the Fund will disclose on its Web site the identities and quantities of the money market securities and other assets held by the Fund that will form the basis for the Fund’s calculation of NAV at the end of the Business Day.”). 48. SEC Proposed Rules, supra note 3, at 14,623. 49. Id. 50. Id. at 14,642. 51. As the SEC explains, “[a]n ETF that chooses not to disclose its portfolio would have to track an index whose provider discloses the identities and weightings of the securities and other assets that constitute the index in order to rely on the proposed rule.” Id. at 14,642-43. 52. Authorized participants are institutional investors that create ETFs by acquiring the necessary portfolio securities. See, e.g., CHRISTINE BRENTANI, PORTFOLIO MANAGEMENT IN PRACTICE 167 (Elsevier Ltd. 2001) (2004) (explaining that, when demand for an ETF is expected, a large intermediary broker/dealer or authorized participant buys securities representing an underlying index). 53. Portfolio deposits “essentially need to match the index underlying the fund and be acceptable to the fund’s adviser.” Reg. of Inv. Companies, supra note 15, § 26.02[1][a]. 54. See Bansal & Somani, supra note 29, at 40 (discussing ETF formation); Phyllis J. Bernstein, A Primer on Exchange-Traded Funds, J. ACCT., Jan. 1, 2002, at 39-40 ( discussing the ETF share-creation process). 2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 103 creation unit, which typically contains 50,000 or more shares of the ETF.55 Because the value of a creation unit will equal that of its corresponding ETF shares,56 portfolio deposits may include a small amount of cash to balance differences between the value of the deposit and the shares’ NAV.57 Investors also may acquire creation units on the secondary market by purchasing a sufficient number of shares.58 As a result, ETFs operate in two markets; creations and redemptions define the primary market, while investors who trade shares on an exchange create the secondary market.59 ETF shares are redeemed through “in kind” transfers, which exchange creation units for their underlying portfolio securities.60 ETF shares are not redeemable individually,61 a feature that distinguishes them from most open-end funds.62 Redemptions are priced by the end-of-day NAV and thus protect shares from dilution.63 In-kind redemption also shelters ETF shareholders from the tax consequences of cash-redeemable mutual funds,64 as in-kind redemption uses a direct securities transfer rather than a 55. Stuart M. Strauss, Exchange Traded Funds—the Wave of the Future? 7 INVESTMENT LAWYER 1, 15 (2000). 56. Actively Managed Exchange-Traded Funds, Investment Act Release No. IC-25258, 66 Fed. Reg. 57,614, 57,616 (Nov. 8, 2001). 57. Id. 58. See, e.g., Bernstein, supra note 54, at 39 (noting that broker-dealers often break up creation units and offer ETF shares on the exchanges where individual investors can buy them). 59. See Ragozino & Gambino, supra note 28, at 3 (explaining that there are really “two markets” for ETFs); see also DOUGLAS S. ROGERS, TAX AWARE INVESTMENT MANAGEMENT 106 (Bloomberg Press 2006) (listing the two types of markets for ETFs as a primary market of authorized participants and a secondary market of individual investors); Ira P. Shapiro, An Introduction to U.S. ETFs, in PRACTISING LAW INST., NUTS & BOLTS OF FIN. PRODUCTS 2008 357, 361 (2008) (stating that most investors buy and sell ETF shares on the exchange, instead of making direct purchases and redemptions from the fund itself as they would do with index mutual funds); Letter from Philippe El-Asmar, Managing Dir., Barclays Capital Inc., to Nancy M. Morris, Sec’y, Sec. & Exch. Comm’n 2 (May 8, 2008) (on file with author), http://www.sec.gov/comments/s7-07-08/s70708-4.pdf (noting transactions with ETFs are limited to Authorized Participants, whereas “retail investors purchase and sell ETF shares in secondary market transactions”). 60. BRENTANI, supra note 52, at 167. 61. See, e.g., Actively Managed ETFs, supra note 56, at 57,621 (“Because ETF shares are not individually redeemable, an ETF requests relief to permit the ETF to register and operate as an open-end fund and to issue shares that are redeemable in Creation Units only.”). 62. See Investment Company Act, 15 U.S.C. § 80a-5(a)(1) (2000) (indicating that open- end funds traditionally redeem all shares). 63. American Stock Exchange LLC, Explanation of ETFs, http://www.amex.com/?href=/etf/eductn/etf_edu_instit.html (last visited Oct. 16, 2008). 64. The following is a summary of the two primary tax advantages of ETFs over mutual funds: First, because retail investors go directly to the market to obtain cash for their shares, the fund manager does not have to sell shares that would trigger capital- 104 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1 sale yielding taxable gains.65 Capital gains taxes are deferred until investors sell the securities,66 which in turn controls costs for the remaining shareholders67 and supports the claim that in-kind creation and redemption provide for “relatively frictionless portfolio turnover.”68 D. The Arbitrage Mechanism ETF shares trading on secondary exchanges can experience deviations between share price and the NAV of their underlying portfolio securities.69 While ETF share prices track the NAV of the fund’s portfolio securities,70 short-term differences between the two prices nonetheless occur.71 The trading environment causes this deviation, marking a critical difference between an ETF and an open-end mutual fund. The share price of an open- end mutual fund “always equals its NAV,”72 which, coupled with the gain distributions for the remaining shareholders. Second, creation unit holders can redeem their shares for the underlying stock rather than cash, thus deferring the gain or loss until the distributed shares are sold by the investor. See, e.g., Randy Gardner & Julie A. Welch, Increasing After-Tax Returns with Exchange Traded Funds, J. FIN. PLANNING, June 2005, at 31, available at http://www.fpanet.org/journal/articles/2005_Issues/jfp0605-art4.cfm. 65. See Kathleen Moriarty, Exchange-Traded Funds: Legal and Structural Issues Worldwide, 29 INT’L BUS. L. 346, 349 (2001) (“[T]he ETF satisfies redemptions by providing the redeeming party with the actual basket of designated stocks, rather than cash proceeds resulting from the sale of such stocks . . . .”); see also Svea Herbst-Bayliss, Fidelity Opens Magellan Fund to New Investors, REUTERS, Jan. 14, 2008, http://www.reuters.com/article/companyNews/idUSN1441753420080114 (reporting that Fidelity re-opened its Magellan mutual fund to new investors following increasing withdrawals by retirees, which frequently forced the fund manager “to sell stocks he liked in order to have enough cash on hand to meet redemptions”). 66. See Gardner & Welch, supra note 64, at 31 (citing this as a tax advantage); see also Stout & Chen, supra note 45, at 57 (explaining in regard to the in-kind redemption process: “According to the IRS, this exchange of essentially identical items does not trigger capital gains. Thus, ETF shares allow an investor to delay payment of capital gains tax until the final sale of the ETF shares.”). 67. See Gardner & Welch, supra note 64 (contrasting the relatively high capital gains taxes associated with regular mutual funds with those associated with ETFs). 68. Moriarty, supra note 65, at 348. 69. Plante Moran Fin. Advisors, Exchange-Traded Funds Revisited 1 (2006), http://www.plantemoran.com (search “Exchange-Traded Funds Revisited”; then follow “full article” hyperlink). 70. Stuart Strauss & Scott M. Zoltowski, Exchange Traded Funds, in A.L.I.-A.B.A., INVESTMENT MGMT. REG. 67, 70 (Aug. 2006). 71. See John Demaine, Exchange Traded Funds for the Sophisticated Investor, 7 DERIVATIVES USE, TRADING & REG. 354, 355 (2002) (“While both ETFs and futures tend to track underlying cash indices tightly over a period of time, in the short term they can trade significantly away from ‘fair value.’”). 72. Plante Moran Fin. Advisors, supra note 69, at 1.