SEC Division of Investment Management staff letter: Investment Company Institute

¹ We refer to a creation basket that approximately reflects a pro rata representation of the ETF’s portfolio holdings as a “pro rata creation basket.” We refer to other creation baskets as “non-pro rata creation baskets,” which may include custom baskets, as defined in Rule 6c-11, as well as baskets that reflect a representative sample of the ETF’s portfolio holdings or changes due to a rebalancing or reconstitution of the relevant index, if applicable.

² The Investment Company Institute (“ICI”) is the leading association representing the asset management industry in service of individual investors. ICI’s members include mutual funds, ETFs, closed-end funds, and unit investment trusts in the United States, and UCITS and similar funds offered to investors in other jurisdictions. Its members manage $47.7 trillion invested in funds registered under the 1940 Act, serving more than 125 million investors. Members manage an additional $10.8 trillion in regulated fund assets

I. BACKGROUND AND RELEVANT LAW

The 1940 Act requires a registered fund to disclose its policy regarding concentrating investments in a particular industry or group of industries in its registration statement.³ A fund, including an ETF, generally may not deviate from its policy on concentration without a vote of shareholders.⁴ These requirements operate to inform fund shareholders concerning each fund’s policy on concentration and allow shareholders to weigh in concerning any changes in such policy.⁵

Changes in market values may from time to time cause an ETF’s investments in a particular industry or group of industries to exceed 25% of its assets, notwithstanding the ETF’s disclosed policy not to concentrate in any industry. Such an exceedance is passive and the result of factors external to the ETF’s management.

Starting in the 1970s, the SEC published Staff guidance on fund concentration establishing that, when a passive exceedance exists:

(1) The affected fund may not make further investments in the relevant industry; but

(2) The fund need not sell the excess.⁶

managed outside the United States. ICI also represents its members in their capacity as investment advisers to collective investment trusts (“CITs”) and retail separately managed accounts. ICI Associate Members include service providers to member firms and CIT trust companies. ICI has offices in Washington DC, Brussels, and London.

³ See Section 8(b)(1)(E) of the 1940 Act. Form N-1A, the form ETFs and mutual funds use to prepare their registration statements, instructs funds to disclose their concentration policies and explains that concentration means “investing more than 25% of a Fund’s net assets in a particular industry or group of industries.” Form N-1A, Item 9(b)(1), Instruction 4.

⁴ See Section 13(a)(3) of the 1940 Act. In addition, Section 34(b) of the 1940 Act provides, in relevant part, that, “[i]t shall be unlawful for any person to make any untrue statement of a material fact in any registration statement, application, report, account, record, or other document filed or transmitted pursuant to this subchapter....”

⁵ See, e.g., House of Representatives Hearings before the Subcommittee of the Committee on Interstate and Foreign Commerce at 115 (statement of David Schenker) (June 14, 1940) (“Section 13 merely provides that once you have told your stockholders what type of company you are, the type of activity that you are going to engage in, you cannot, overnight, change the fundamental nature of your business without telling your stockholders, and getting their consent.”)

⁶ See Release No. IC-7221, 37 Fed. Reg. 12,790 (June 9, 1972) (rescinded). See also Release No. IC-13436, 48 Fed. Reg. 37,928 (SEC approval Aug. 12, 1983; pub. Aug. 22, 1983) (rescinded). Although the SEC later

In many cases, following this simple distinction is reasonably straightforward: when a passive exceedance exists, the fund’s manager cannot make an investment that causes further concentration in the relevant industry, but the manager may not be forced to reduce the fund’s position. This guidance, however, was developed in the context of traditional funds and does not address how ETFs should treat in-kind baskets during a passive exceedance.

Unlike traditional mutual funds, ETFs issue and redeem shares in creation units through authorized participants (“APs”)⁷ who deliver a “creation basket” consisting of securities and, when applicable, cash-in-lieu. In return, the AP receives a fixed amount of ETF shares, called a “creation unit.”⁸

SEC guidance limits the circumstances under which an ETF can close to new investments.⁹ As a result, an ETF’s manager generally cannot control the timing of creations. In this way, the submission of a creation order may increase the ETF’s holdings of securities in an industry in which it is experiencing a passive exceedance at the times the ETF’s portfolio manager generally does not choose. Accordingly, the ETF share creation process presents considerations that the previous guidance on passive exceedances, which principally addresses traditional portfolio management decisions, does not discuss.¹⁰ We believe the Requested Position would be helpful to both actively-managed and index-based ETFs, each of which could confront the circumstances discussed herein.

II. DISCUSSION

We believe the Requested Position would be appropriate because, under the circumstances described herein, any exceedance of a concentration policy exists as a result of factors external to the ETF’s management – market movements leading to a passive exceedance and the submission of a creation order by an investor – rather than a choice by the ETF’s manager to invest assets on that day. Moreover, when an ETF accepts a pro rata creation basket, the percentage of the ETF’s portfolio invested in an industry stays the same (setting aside market movements). The ETF scales

rescinded the guides to Form N-1A, registrants and their counsel still look to them for guidance on various subjects, including with respect to requirements related to concentration policies. See Release No. IC-23064, 63 Fed. Reg. 13916 (Mar. 23, 1998) (rescinding the guides to Form N-1A).

⁷ An AP is typically a large financial institution that enters into a legal contract with the ETF’s distributor to create and redeem shares of the fund.

⁸ See ETF Basics and Structure: FAQs, Investment Company Institute (Apr. 28, 2025), available at https://www.ici.org/faqs/faqs_etfs.

⁹ See Exchange-Traded Funds, Release No. IC-33646, 84 Fed. Reg. 57162 (Sept. 25, 2019), at note 186 et. seq.

¹⁰ See supra note 1 and accompanying text.

up, but the basket essentially maintains the ETF’s concentration status quo. From the perspective of any individual shareholder, concentration has not increased.

The Staff has previously considered, under similar circumstances, situations where exceedances of a 1940 Act limitation may arise on a “non-volitional” basis – i.e., as a result of factors external to a fund’s portfolio management. For example, the Requested Position would be consistent with guidance from the Staff concerning diversification policies and investments in securities-related businesses.¹¹ In the Stradley Letter, the Staff addressed similar considerations in the context of diversified index-based funds. The Staff stated that it would not recommend enforcement action when “an index-based fund, solely as a result of tracking its target broad-based index, would cease to be a diversified company as a result of a change in relative market capitalization or index weighting of one or more constituents of the index.”

Similarly, the Staff’s Victory Letter permitted an index fund to invest in bank stocks of an affiliate of the fund’s adviser even though Rule 12d3-1 is generally not available for investments in such entities.¹² The Staff agreed that, in the context of Rule 12d3-1, purchases and sales of the stocks by the fund – which were “in accordance with directions generated by computer models designed to match the performance of the [index]” – were “non-volitional.”¹³

Although these prior no-action letters address only index-based funds, and the guidance requested herein would apply to both actively-managed and index-based ETFs, the principles underlying the Requested Position are similar. Those letters recognize that, where an exceedance is non-volitional, it does not raise the policy concerns that the relevant 1940 Act limitation was designed to address. In the case of ETFs, whether actively-managed or index-based, SEC guidance has limited the

¹¹ See, e.g., Stradley Ronon Stevens & Young, LLP, SEC Staff No-Action Letter (pub. avail. June 24, 2019) (the “Stradley Letter”); and Victory Stock Index Fund, SEC Staff No-Action Letter (pub. avail. Feb. 7, 1995) (the “Victory Letter”).

¹² The rule states that it “does not exempt the acquisition of... [a] security issued by the acquiring company’s investment adviser, or an affiliated person of the acquiring company’s investment adviser,” except in the case of subadvisers. Rule 12d3-1(c)(3).

¹³ See also Select Sector SPDR Fund and Diamonds Trust, SEC Staff No-Action Letter (pub. avail. July 6, 2000) (exceeding the 5% asset test in Rule 12d3-1(b)(3) under the 1940 Act “does not raise the concerns that underlie Section 12(d)(3)” where a fund’s objective is to follow a broad-based securities market index or sectors classifications thereof); and SPDR S&P Dividend ETF, SEC Staff No-Action Letter (pub. avail. Mar. 28, 2016).

ability of funds to close to new orders. As a result, an ETF has limited control over the timing of new investments in ETF shares.¹⁴

These principles become even clearer when considering the inverse of the Requested Position. If an ETF with a passive exceedance of an industry concentration limit could not accept a creation basket that includes investments in the relevant industry, it would need to exclude certain securities from the basket to avoid industries that the exceedance affects. This would mean either requiring a non-pro rata creation basket or substituting cash-in-lieu and deploying the cash non-pro rata. In this scenario, the manager would need to make a determination of what to substitute for the relevant industry securities.

The result would be similar to requiring a fund to reduce its exceedance and re-invest in another industry, a result that the SEC has not required. Although this would not force the sale of a current holding, it could have a similar negative effect by increasing exposure to other industries at a time when the manager judges such increase to be undesirable based on market conditions.

We believe the Staff’s prior guidance on concentration policies was intended to avoid exactly these situations because of the potential for harm to shareholders. When shareholders invest in a fund, they are seeking the benefit of the manager’s judgment and skill. This benefit includes not only the selection of securities (and, therefore, industries) for investment but also the determination of when to invest or divest. The guidance on concentration is just one example of Staff guidance and SEC policy designed to avoid forcing funds to sell assets at inopportune times.¹⁵ The common thread is that, when a manager cannot determine the timing of changes to a fund’s portfolio, ill-timed changes in exposure may result in harm to shareholders.

Just as the Staff’s prior guidance on concentration avoids forcing sell-downs, the potential for harm also exists where a manager is required to accept substitute assets. Consider, example, if a fund with a policy not to concentrate held 26% of its portfolio in auto industry investments as a result of

¹⁴ We are not requesting that the Requested Position apply to mutual funds, or mutual fund share classes, because of the differences in regulation concerning the purchase of mutual fund shares compared to ETF shares.

¹⁵ See, for example, Rule 22e-4 under the 1940 Act (the liquidity rule), which requires a fund to engage in planning when an exceedance exists but does not force sales, which the SEC recognized could harm fund shareholders. Investment Company Liquidity Risk Management Programs, SEC Rel. No. IC-32315 (Oct. 13, 2016), at 236 (“We believe that requiring a fund to divest illiquid investments if the fund’s holdings of illiquid investments that are assets exceed 15% of net assets—which, as suggested by a commenter, could result in the fund needing to sell the illiquid investments at prices that incorporate a significant discount to the investments’ stated value, or even at fire sale prices—could adversely affect shareholders and could potentially negate the liquidity risk management benefits of the illiquid investment limit.”).

market movements. Forcing the fund to remove auto industry investments from its creation basket would mean increasing the fund’s proportionate exposure to, for example, healthcare investments or technology investments at a time when the fund’s manager may or may not view those as desirable investments.

We believe the Requested Position would also benefit ETF shareholders because the alternatives to the Requested Position, like seeking shareholder approval to change the ETF’s concentration policy, may impose significant costs. Without the Requested Position, an ETF could also see a negative impact on the quality of the secondary market for its shares. We understand that market makers consider consistency of experience with an ETF important to whether they are willing to provide liquidity in the shares. For example, if ETFs are more regularly required to use cash-in-lieu to avoid securities in a relevant industry, market makers may negatively price in the unpredictability of when those securities will be transferred in kind or substituted for cash-in-lieu. Investors may feel this effect through increased spreads.

III. SCOPE OF REQUESTED POSITION

We ask that the Requested Position address three scenarios that may occur at a time when an ETF is experiencing a passive exceedance of its disclosed concentration policy with respect to investment in an industry. We believe each scenario is important because, as a practical matter, each may arise frequently. Addressing only one or two of these scenarios would leave gaps with the potential for the harm to shareholders discussed above.

Scenario 1: At a time when an ETF is experiencing a passive exceedance of its disclosed concentration policy with respect to investments in an industry, the ETF may accept a pro rata creation basket that includes one or more investments in the relevant industry. For the reasons discussed above, we believe the Requested Position in this scenario would benefit ETF shareholders and is consistent with the policy underlying prior Staff guidance concerning concentration policies and similar requirements under the 1940 Act.

Scenario 2: If part of the creation basket is to be received as cash-in-lieu of a creation basket component and such component represents an investment in the relevant industry, the ETF may purchase the component security up to the amount consistent with a pro rata creation basket.

Although, compared to the first scenario, the ETF takes an additional step in the process – turning the cash into securities in the relevant industry – the result and arguments are essentially the same. Moreover, similar to how the timing of creation orders is generally outside the control of ETF managers, using cash-in-lieu to purchase a basket component in the relevant industry up to the amount that would have been received in a pro rata basket is likewise driven by factors external to

the ETF’s management. The need for cash in-lieu generally arises from circumstances unrelated to portfolio management, such as small lots or restrictions on in-kind transfers.

Scenario 3: The ETF may receive a non-pro rata creation basket where the weighting of the relevant industry is consistent with the weighting that would have applied in a pro rata creation basket. We assert that accepting such a basket is consistent with Staff guidance and the policy underlying the concentration limitations. Moreover, as regards concentration in the relevant industry, this scenario has the same effect as the first scenario from the perspective of shareholders. For example, if an exceedance exists because the ETF holds 26% of its portfolio in auto industry investments, the shareholder would experience an exposure of 26% both before and after the creation order is processed (setting aside market movements). Changes to the weighting of other industry securities are not relevant to how the exceedance is addressed.

In this scenario, absent the no-action position requested, an ETF experiencing a passive exceedance could be forced to take certain actions, such as altering basket composition or substituting assets, that may disadvantage shareholders. For example, assuming again an exposure of 26% to auto industry investments, the non-pro rata basket may increase exposure to healthcare investment A and decrease exposure to healthcare investment B, leaving the overall exposure to the healthcare industry – and the overall industry mix – unchanged. Alternatively, a non-pro rata basket may increase exposure to the healthcare industry in order to reduce exposure to the technology industry because the manager believes that mix is more beneficial to the ETF at that time. Requiring the manager to, instead, offset the increased exposure to the healthcare industry with a reduction in exposure to the auto industry would fail to achieve the intended portfolio management result. In other words, even in the case of a non-pro rata basket, permitting the submission of a creation order to drive the timing of a reduction in industry concentration may harm shareholders for the reasons discussed above.

IV. CONCLUSION

We believe that the Requested Position would enable ETFs, whether actively-managed or index-based, to continue to pursue their investment objectives in the best interests of shareholders. The Requested Position would minimize the portfolio management disruption during a passive exceedance. We also believe that the Requested Position would enable ETFs and their shareholders to avoid the significant costs associated with seeking shareholder approval to change their concentration policies and potential negative impacts on the quality of the secondary market for

ETF shares as described herein. Accordingly, we respectfully request that the Staff grant the Requested Position.

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If you have any questions or comments regarding this letter, please do not hesitate to call David P. Bartels at (202) 261-3375, Allison Fumai at (212) 698-3526, Stephen T. Cohen at (202) 261-3304 or Kimberley Church at (202) 261-3358. We appreciate your assistance in this matter.

Very truly yours,

[Signature: Dechert LLP]

Dechert LLP