This alert highlights certain recent trends of interest in the exchange-traded fund (ETF) industry. It discusses recent developments concerning conversions of investment companies registered under the Investment Company Act of 1940 (1940 Act) that are open-end (mutual funds) into ETFs, amendments to the standard exemptive relief for active semi-transparent ETFs (ST ETFs) utilizing the proxy portfolio approach and developments regarding the use of cryptocurrencies in ETFs.
Funds Converting to ETFs
I. Mutual Fund Conversions
Three fund sponsors recently successfully converted mutual funds into ETFs. On March 17, 2021, Guinness Atkinson converted two of its sponsored mutual funds, Guinness Atkinson Asia Pacific Dividend Builder Fund and Guinness Atkinson Dividend Builder Fund (the “Guinness Atkinson Funds”) into SmartETFs Asia Pacific Dividend Builder ETF and SmartETFs Dividend Builder ETF, respectively. The Guinness Atkinson Funds relied on Rule 17a-8 under the 1940 Act to reorganize the funds into ETFs without shareholder approval. On May 7, 2021, a mutual fund advised by Cavalier Investments, LLC d/b/a Adaptive Investments reorganized into Adaptive Growth Opportunities ETF, a “shell” ETF that had the same strategy as the fund. Dimensional Fund Advisers (DFA) announced on November 17, 2020 plans to convert six funds into corresponding ETFs. The SEC declared the registration statement filed by DFA relating to the conversions of four of these funds effective on April 6, 2021. DFA announced that these funds were successfully converted on June 14, 2021. The conversions of the other two funds advised by DFA into ETFs are expected to occur on or around September 10, 2021.
Each of these sponsors structured the conversions as reorganizations. In general, there are two methods for converting a mutual fund into an ETF or ST ETF: direct conversion or reorganization. In a direct conversion, the mutual fund would modify its organizational documents, service provider agreements and registration statement to permit ETF operations. In a reorganization, the mutual fund would reorganize into a new “shell” ETF whose organizational documents, service provider agreements and disclosures contemplate ETF operations. In addition, the “shell” ETF into which the mutual fund reorganizes would have materially the same investment objectives, strategies, policies and restrictions as the fund.
Other mutual fund sponsors have announced and taken steps to execute mutual fund to ETF conversions.
II. Private Fund Conversions
ETF conversions have not been limited to mutual funds. Private funds have joined the action. For example, Upholdings Compound Kings ETF, which launched on December 30, 2020, was converted from a private fund advised by Upholdings Group, LLC.
S&K Observations
We expect these types of ETF conversions to expand significantly in the coming months and years, as the ETF structure offers several advantages that investors (including registered advisers) find attractive. For a discussion of certain of those advantages, see “Can the Tax Efficiencies of ETF Redemptions In-Kind Be Replicated for Mutual Funds?” by Paul M. Miller and Christopher D. Carlson, which appeared in the February 2020 issue of The Investment Lawyer.1 In addition, to assist our clients and others with considering the conversion process, we have developed a summary outline of issues and matters to consider. We also expect other types of funds, like private funds, to seriously consider conversions, provided their portfolios have the liquidity required to support the ETF structure.
Developments Regarding ST ETF Exemptive Relief
An ST ETF is an ETF that does not disclose its full portfolio holdings each day and instead discloses alternative information about the ST ETF’s portfolio, such as a portfolio of securities that are expected to be highly correlated with the ST ETF’s actual portfolio (proxy portfolio), or an intraday estimate of the ST ETF’s NAV each second throughout the trading day, that is intended to help facilitate the arbitrage process. Unlike fully transparent ETFs that can rely on Rule 6c-11 under the 1940 Act, ST ETFs must obtain exemptive relief from the SEC to operate in compliance with the 1940 Act. To date, this relief has been tailored to two types of ST ETFs, either a “proxy portfolio” ST ETF or a “blind trust” ST ETF. A proxy portfolio ST ETF uses its proxy portfolio as the creation and redemption basket for the ST ETF, which limits the tax advantages that ETFs ordinarily have by being able to transact in portfolio securities that have unrealized capital gains. A blind trust ETF keeps the securities in its creation and redemption baskets confidential by requiring authorized participants (APs) to transact through an “AP Representative.” This permits the blind trust ST ETF to include its actual portfolio holdings in creation and redemption baskets that are exchanged with APs for creation units of the ST ETF without the concern of those holdings being disclosed to the marketplace.
Multiple proxy portfolio ST ETF sponsors have recently obtained amended exemptive relief mitigating this drawback. The relief provides an ST ETF the same ability to use “custom baskets” for the proxy portfolio of securities as an ETF that relies on Rule 6c-11.2 The relief permits the ST ETF manager to substitute securities that are not included in the proxy portfolio for other securities that are not believed to create the risks of “front-running” or “free riding” on the ST ETF’s manager’s strategy, subject to additional recordkeeping and procedural requirements.
S&K Observations
This amended exemptive relief for proxy portfolio ST ETFs should expand the utility of pursuing launching these types of ST ETFs. An ST ETF could rely on this relief to include a portfolio security with embedded capital gains from its actual portfolio in its redemption basket that would be transferred to an AP redeeming creation unit(s) with the ST ETF without recognizing the gain on the portfolio security. This approach would mitigate the tax disadvantage of having to use the ST ETF’s proxy portfolio as the redemption basket.
Announcements regarding Cryptocurrency ETFs
Grayscale Bitcoin Trust (BTC) (Grayscale), which holds bitcoin and whose shares are quoted on OTC Markets Group Inc.’s OTCQX® Best Marketplace under the symbol “GBTC,” recently announced its intention to convert into a bitcoin ETF.3 Grayscale’s filing did not specify how such a conversion would occur. Shortly after this announcement, on April 14, 2021, ClearShares LLC, a sponsor of ETFs registered under the 1940 Act (ClearShares), simultaneously announced an investment in ClearShares by Grayscale Investments, LLC, Grayscale’s sponsor, and a change in ticker symbol for one of ClearShares’ fixed income ETFs (ClearShares Piton Intermediate Fixed Income ETF (ClearShares ETF)) from “PIFI” to “BTC,” which suggested a future change in strategy involving bitcoin.4 However, on May 7, 2021, these plans apparently changed as the ClearShares ETF announced a change in this ticker symbol back to PIFI.5
The ClearShares ETF is registered under the 1940 Act. The SEC’s Division of Investment Management (IM) has previously announced a willingness to engage with sponsors regarding investments in cryptocurrencies such as bitcoin.6 IM also approved the first fund registered under the 1940 Act with a principal investment strategy of investing in bitcoin futures. A recent IM staff statement encouraged ETFs that intend to invest in bitcoin futures to consult with the staff prior to filing a registration statement on how such ETFs intend on ensuring compliance with the federal securities laws, which indicates that the staff is taking a cautious approach towards the use of bitcoin futures as a strategy in an ETF.
S&K Observations
Although progress towards recognition by the SEC of cryptocurrencies as an acceptable investment by funds has been very slow, we believe that the use of cryptocurrencies by funds as a complement to existing strategies or as a primary strategy will continue to grow and develop as the use of cryptocurrencies as an investment strategy or as a complement to existing strategies becomes more prevalent. This process should accelerate as funds continue to use cryptocurrencies in compliance with law and while addressing regulatory concerns. Gary Gensler, the new Chair of the SEC, has stated in recent testimony to Congress his belief that there are regulatory gaps in cryptocurrency markets, such as the lack of audited or reported transactions on unregistered exchanges, and that these present greater opportunities for fraud and manipulation.7
