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Sunday, May, 2, 2010

W. Thomas Conner (Sutherland, Asbill & Brennan LLP) examines the state of the exchange traded product market

PLI: Exchange traded products continue to explode in popularity. Can you give us an update on the scope of these products and the market?

W. THOMAS CONNER: Exchange traded funds or "ETFs" are a relatively new type of investment vehicle. From an investment perspective, most ETFs function as index mutual funds. Unlike indexed-based mutual funds, however, ETF shares trade on an exchange and investors can buy and sell shares throughout the day at market determined prices. This feature, potentially greater transparency and liquidity than mutual funds, the opportunity for use in sophisticated trading and hedging strategies, and lower costs and certain tax advantages, have made ETFs more popular with some investors than conventional mutual funds.

These relative advantages have contributed to fast growth in the ETF market. By one estimate, since the first ETF was introduced in 1992, assets grew to $417 billion by year-end 2006. It took the U.S. mutual fund industry from 1924 to 1984 to grow to this level of assets. ("Exchange-Traded Funds, Volume 1, The Professional's Pocket Guide," Powershares Corporate Library, December 2006.) By year-end 2008, the number of ETFs had grown to 728 and total assets had grown to $531 billion. See 2009 Investment Company Fact Book, available at http://www.icifactbook.org.

ETFs are regulated like mutual funds under the federal securities laws, but their unique structural and operational characteristics require exemptions from the Securities and Exchange Commission ("SEC" or the "Commission") that mutual funds do not need. At the end of the day though, forming, registering, and operating a conventional ETF is, at this point, relatively "old hat" from a regulatory standpoint.

Recent years have seen the development of a new type of exchange traded product that tracks the performance of specified commodities, currencies or other "hard assets." This outline refers to these products as "exchange traded vehicles" ("ETVs"). Because ETVs invest in commodities, currencies, or other hard assets, they are not subject to the Investment Company Act of 1940 (the "1940 Act"), the special set of statutes and rules that govern mutual funds, ETFs, and other types of investment companies. However, ETVs are subject to the same registration requirements that apply to mutual funds, ETFs and other investment companies under the Securities Act of 1933 (the "1933 Act"), plus additional rules under the 1933 Act and the Securities Exchange Act of 1934 (the "1934 Act") that do not apply to funds.

Yet another variation on the ETF theme is the "exchange traded note" or "ETN." Like ETFs and ETVs, ETN shares trade in the secondary market and seek to provide investors returns based on underlying securities, commodities or other indexes. Importantly, however, ETNs do not seek to track the index by investing in the component securities or commodities comprising the index; rather, ETNs are notes constituting the general debt obligation of a bank issuer. Unlike conventional notes, however, ETNs do not promise the return of an investor's principal at maturity. Instead, the amount due at maturity is determined by reference to the underlying index. This structural characteristic of ETNs is designed to eliminate the potential for tracking error inherent in ETFs and ETVs, but ETN investors are subject to the general credit risk of the issuer and there are potential tax issues.

More from W. Thomas Conner — Download Evolution of Exchange Traded Products: How New SEC Rules May Tip the Competitive Balance

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