|To Swap Or Not To Swap|
|November 28, 2012-|
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Uneven fund rules mean competing exchange-traded fund issuers have to use quite different structures to achieve a similar investment objective. And there’s little immediate prospect of the playing field being levelled.
A number of ETF providers have recently launched or applied to issue new tracker funds offering hedged exposure to corporate bonds.
In the US ETF market ProShares, the largest local issuer of leveraged and inverse exchange-traded funds, this week filed regulatory paperwork to market a high-yield corporate debt fund that will hedge exposure to corporate debt by taking short positions in US Treasury bonds via derivatives contracts.
In its filing, ProShares makes it clear that it intends to protect investors against future rises in government bond yields, while continuing to offer exposure to the excess yield offered by lower-quality credits.
The ProShares High Yield-Interest Rate Hedged ETF filing is the third application made this autumn to the US securities market regulator, the SEC, to propose combining an investment in junk bonds with an offsetting interest rate hedge via short sales or the use of derivatives. The two other US filings come from FirstTrust and Market Vectors.
In its filing to the SEC ProShares proposes to make use of its existing “exemptive relief” from the 1940 Investment Company Act, the governing regulation for the majority of US mutual funds.
Exemptive relief means that the SEC exempts an applicant from certain provisions of the 1940 Act; achieving it requires a time-consuming application process, including an obligatory public comment period.
ProShares received exemptive relief for a range of leveraged and inverse ETFs, which rely heavily on the use of derivatives contracts to achieve their investment objective, in 2006.
Since 2009, however, the SEC has maintained an effective ban on new ETF launches using derivatives. This has resulted in an uneasy and confusing truce, under which a few ETF issuers that already had derivatives-based fund ranges in place—notably ProShares and Direxion—can continue to offer them, while other firms cannot follow suit.
“Currently there are different bans in place in the US, resulting in different rules for product providers, depending on what your products are and when you got into the market in the first place,” Jeremy Senderowicz, a New York-based lawyer at Dechert LLP told IndexUniverse.eu.
“One current moratorium prevents new providers from setting up inverse and leveraged ETFs,” Senderowicz went on, “although firms like ProShares may continue to do so.”
“Another ban prevents an index underlying an ETF to be based on derivatives. And a third affects any actively managed ETFs unless they promise not to use options, futures or swaps at all.”
“But those managers who obtained exemptive relief to offer active ETFs before late 2009 can continue to use derivatives in their funds,” Senderowicz added.
By contrast with the derivatives-based ProShares filing, the applications by First Trust and Market Vectors to manage hedged high-yield bond ETFs rely on short selling of Treasuries to achieve the desired interest rate hedge.
The SEC has permitted the limited use of short sales within 1940 Act mutual funds since the 1970s. However, short sales are subject to limits on a fund’s overall leverage, which constrain short exposure to around a third of the portfolio’s overall value.
This, in turn, means that the First Trust and Market Vectors ETFs may only be able to offer partial interest rate hedges for their corporate bond exposures, compared to the greater flexibility enjoyed by ProShares through its use of derivatives contracts.