On March 25th, the SEC announced that it is going to defer granting exemptive relief to certain funds and ETFs which invest significantly in derivatives, while it conducts a review of the usage of these instruments in mutual funds and ETFs. Filing for exemptive relief under the Investment Company Act is one of the most important and initial steps in bringing actively-managed ETFs to market. The release specifically mentions that certain requests from actively-managed ETF issuers and leveraged ETF issuers are going to be impacted by this deferment.
On the surface, this development does appear to throw some water on the recent flood of big names filing to launch Active ETFs. However, it should be noted that this review is likely targeted more toward leveraged and commodity ETFs that have gotten a lot of negative press of late. Also, an important distinction is the degree of reliance of each type of ETF on the use of derivative instruments. Nearly all leveraged ETFs rely extensively on the use of derivatives in order to provide the 2x or 3x leverage on the underlying index. Likewise, certain types of commodity ETFs, such as those relying on futures, are also very dependent on the use of derivatives to meet their investment mandates.
Most actively-managed ETFs so far have only used derivatives, if at all, as a means to hedge risks in their portfolios. While the statement has made clear that existing ETFs on the market will not be impacted by this review, it’ll be helpful to look at how Active ETFs currently on the market utilize derivatives in order to gauge how new offerings might be effected. Of the 17 Active ETFs in the US, none of the equity ETFs makes use of derivatives. It is usually the fixed-income products that utilize derivatives, such as swaps and futures, for risk management purposes. For example, the Grail McDonnell Intermediate Municipal Bond ETF (GMMB) and the Grail McDonnell Core Taxable Bond ETF (GMTB) are the only two active bond ETFs that use derivatives for hedging. PIMCO’s three active bond ETFs explicitly state that they do not use any derivatives in their portfolios, something that might work in PIMCO’s favor now. Other than this, the only other Active ETF currently on the market that utilizes derivatives is the BlackRock iShares Diversified Alternatives Trust (ALT) which uses a variety of currency forwards as well as futures on commodities, currencies, interest rates, equity and bond indices to implement its hedge-fund like strategy.
I would expect the SEC to treat upcoming active bond ETFs, such as those filed by the likes of Eaton Vance, more leniently provided they can show that they are only utilizing derivatives for risk management purposes. As such, the issuers likely to face stronger headwinds as a result of this development are likely those planning more exotic, alternative asset strategies. A case in point is the Mars Hill Global Relative Value ETF (GRV) which AdvisorShares was planning to launch by April. GRV is generally a market neutral portfolio, but the managers have the ability to implement a directional overlay using futures contracts on equity indices. Whether the ability to use these instruments delays the fund’s launch will become clear in the next few weeks.
Disclosure: No positions in above-mentioned names.