United States: Exchange Traded Funds - The Wave Of The Future?

Exchange Traded Funds (ETFs) have captured the attention of the financial community and the investing public. Press reports abound about the marked increase in trading volume of ETFs and of the keen interest in the development of ETFs expressed by a variety of financial institutions. ¹ By some accounts, over half of the trading volume on the American Stock Exchange is currently attributable to ETFs.

The appeal of ETFs lies in their hybrid structure. Their shares are traded on national securities exchanges like any other exchange traded stock, but unlike other exchange listed investment companies they also afford the investors the ability to purchase and redeem shares on a daily basis, in block size, at net asset value per share (NAV). Because they are traded on exchanges, ETFs afford investors the opportunity to seek to capitalize on market movements (upward or downward) throughout the trading day. Such intraday trading opportunities are not available to mutual fund investors. Moreover, the ability to purchase and redeem at NAV, should insure that the market prices of ETF shares move in response to increases and decreases in NAV and that any temporary disparities between market prices and NAV are closed through arbitrage activity. To date, that has proven to be the case, as demonstrated by the fact that ETFs have generally traded at prices that do not differ materially from NAV. This is in marked contrast to closedend funds that frequently trade at discounts to NAV.

This Article describes the key features of ETFs, the regulatory issues they present, and their operational complexities.

To date, all ETFs have been structured as index funds, which seek to approximate as closely as possible, the performance of a specified index of securities.² ETFs may be organized as unmanaged unit investment trusts (UITs)³ or as managed funds.⁴

The form of organization chosen may, in part, be dependent upon the particular index that the ETF seeks to track (Benchmark Index). If it is practicable to hold all of the securities included in the Benchmark Index in the proportion represented therein (replication), either the UIT or managed form may be chosen. The UIT form would not be appropriate, however, to the extent that replication is not practicable. Replication may not be practicable, for example, with respect to a Benchmark Index comprised of a very large number of securities or to the extent that securities in the index are illiquid.⁵ In these instances, sampling techniques would have to be utilized. These techniques involve selection of a representative sample of securities that, in the aggregate, are expected to perform like the Benchmark Index as a whole. Because a UIT is, by definition, an unmanaged vehicle, any ETF that must utilize sampling techniques would have to be organized as a managed fund.

Other factors that could influence the decision as to whether to organize the ETF as a UIT or a managed fund, include the following: (1) UITs are unmanaged and therefore do not pay management fees (UITs do, however, pay trustee’s fees); (2) a managed fund may invest dividends earned on portfolio securities in repurchase agreements and other shortterm investments; a UIT does not, instead it deposits such dividends in a noninterest bearing account; (3) a managed fund may engage in securities lending and other income enhancement techniques.

Exchange Transactions. ETF shares (Shares) are listed on a national securities exchange (Exchange) and may be purchased at market prices like any other exchange traded stock. Normal brokerage commissions are applicable to such purchases.

NAV Purchases. Shares may be purchased at NAV, in blocks of a specified number of shares (each block is referred to as a Creation Unit). Creation Units are typically at least 50,000 Shares. Purchases are effected through a tender of a specified basket of securities (Deposit Securities) intended to replicate or represent the stocks included in the Benchmark Index. The Deposit Securities are selected in the case of a managed fund by the investment adviser to the ETF, or in the case of a UIT, by the Sponsor of the UIT or Trustee thereto. A small cash payment (Cash Component) generally must also be made. The list of the names and number of shares of the Deposit Securities on a particular trading day is made available daily to market participants prior to the opening of trading by the trustee (in the case of a UIT), or investment advisor or custodian (in the case of a managed fund), typically through the facilities of the National Securities Clearing Corporation (NSCC).⁶ The Cash Component is an amount equal to the Dividend Equivalent Payment (as defined below) plus or minus a balancing amount intended to insure that (consistent with Rule 22c1 under the Investment Company Act of 1940) shares are purchased at NAV next calculated following receipt of the purchase order in proper form.⁷ The Dividend Equivalent Payment is an amount intended to enable an ETF to make a distribution of dividends on the next payment date as if all of the ETF’s portfolio securities had been held for the entire dividend period.

Orders to purchase Shares may be placed by or through a participant (Authorized Participant) in NSCC which has entered into an agreement with the ETF and with the ETF’s distributor (Distributor).⁸.

Trade instructions are transmitted by the Distributor on behalf of the Authorized Participant to NSCC. The Authorized Participant is required to transfer the requisite Deposit Securities and the Cash Component to the ETF on or prior to the 3rd business day following the date on which a purchase order is received in proper form. Delivery of the Deposit Securities and the Cash Component to the ETF is guaranteed by NSCC.

Shares may also be purchased outside of NSCC but it is a more cumbersome and expensive process. Delivery of the Deposit Securities must be made to the ETF in this instance by 11:00 A.M. of the next business day following entry of the purchase order and the Cash Component must be delivered by 2:00 P.M.

Exchange Transactions. Shares may be sold on the Exchange on which the ETF is listed at market prices. Ordinary brokerage commissions are applicable to such sales.

NAV Sales. Shares may be redeemed in Creation Unit size at NAV. Redemptions are effected in kind through a distribution of a basket of portfolio securities. The names and number of shares comprising the basket applicable to redemption requests on a particular day (Fund Securities) are disseminated prior to the opening of trading by the trustee (in the case of UIT), or investment adviser or custodian (in the case of a managed fund), typically through the facilities of NSCC.9 Fund Securities received on redemption may or may not be identical to the Deposit Securities applicable to purchases.

Redemption proceeds include the Fund Securities plus cash in an amount equal to the difference between the NAV of the Shares being redeemed and the value of the Fund Securities.¹⁰ If the value, however, of the Fund Securities is greater than the NAV of the Shares, a cash payment equal to the differential must be paid to the ETF.

Redemptions may be effected by or through an Authorized Participant. Redemption orders are transmitted to NSCC by the Distributor. The Authorized Participant is required to transfer the Shares to the ETF on or prior to the third business day following the date on which a request for redemption is made in proper form. NSCC guarantees delivery of the Shares.

Redemptions may also be effected outside of NSCC but, as in the case of non-NSCC purchases, the process is more cumbersome and expensive. In the case of redemptions outside of NSCC, Shares must be delivered by 11:00 A.M. the next day.

ETFs As Compared To Mutual Funds. ETFs have a tax advantage over mutual funds. Mutual funds pay redeeming shareholders cash for their shares (although redemptions in kind may be effected in limited circumstances) and at times may be forced to sell securities to fund those payments. These sales may in turn generate taxable gains. ETFs, by contrast, effect redemptions in kind and therefore do not have the need to sell securities to fund redemptions. Thus, given similar investment results, an ETF is likely to generate less taxable gain than a mutual fund.

Purchases. A purchase of Shares through a tender of Deposit Securities is a taxable event to the purchaser. The purchaser will recognize a gain or a loss equal to the difference between the market value of the Shares at the time and the purchaser’s aggregate basis in the Deposit Securities and the Cash Component paid.

Redemption. A redemption of Shares is likewise a taxable event to the redeeming Shareholder. The shareholder will generally recognize a gain or loss equal to the difference between such person’s basis in the Shares and the aggregate market value of the securities received and any cash received.

A UIT is defined in section 4(2) of the Investment Company Act of 1940 (1940 Act) as an investment company that, among other things, issues only redeemable securities, each of which represents an undivided interest in specified securities.

A management company is defined in section 4(3) of the 1940 Act as any investment company, other than a UIT (or face amount certificate company). An open-end company is defined in section 5(a)(1) as a management company that issues redeemable securities. A closedend company is defined in section 5(a)(2) as any management company other than an open-end company.

The term redeemable security is defined in Section 2(a)(32) of the 1940 Act as "any security . . . under the terms of which, the owner, upon its presentation to the issuer . . . is entitled to receive approximately his proportionate share of the issuer’s net assets or the cash equivalent thereof."

ETFs issue Shares that are redeemable in Creation Unit size (i.e., typically at least 50,000 Shares). Individual Shares are not, however, redeemable. In light of the non-redeemability of individual Shares, there is an issue as to whether ETFs can be viewed as issuing redeemable securities and therefore entitled to register as a UIT or as an open-end company.

ETFs have addressed the foregoing issue through applications filed with the Securities and Exchange Commission (SEC or Commission) for exemptive relief from sections 2(a)(32) and 5(a)(1) to permit registration as a UIT or as an open-end company, as the case may be, notwithstanding the non-redeemability of the individual Shares. To date, the Commission has been willing to grant this relief.¹¹ In addition, it now appears that the Commission may allow individual applicants to extend such exemptive relief to ETFs to be organized by that Applicant in the future provided that: (1) the rules of the Exchange on which the ETF is traded do not have to be amended to permit such ETFs trading; and (2) the creator, compiler or sponsor of the Benchmark Index is not a first or second tier affiliate of the ETF, the investment advisor to the ETF or the Distributor.

Section 22(d) of the 1940 Act, among other things, prohibits a dealer from selling a redeemable security that is currently being offered to the public by or through an underwriter except at a current public offering price described in the prospectus. Rule 22c1 under the 1940 Act generally requires that a dealer selling, redeeming or repurchasing a redeemable security do so only at a price based on its net asset value per share. Transactions in ETF Shares on an Exchange are effected at market prices; not at the price specified in the fund’s prospectus and not at net asset value per Share. Accordingly, such transactions are not effected in compliance with Section 22(d) and Rule 22c1. ETFs have addressed the issue of compliance with Section 22(d) and Rule 22c1 through applications for exemptive relief to permit secondary market transactions at market prices rather than at net asset value.

ETFs have argued that secondary market trading in Shares does not involve the ETF and therefore cannot result in dilution of Shareholder interests, a concern underlying Section 22(d) and Rule 22c1. In addition, secondary market trades in Shares will not lead to discrimination or preferential treatment among purchasers since anyone can purchase Shares at prevailing market prices. Finally, ETFs have noted that their distribution system will be orderly because the combination of intraday liquidity at market prices and purchases and redemptions at NAV creates potential arbitrage activity that insures that the difference between the market price of Shares and NAV remains narrow.

To date, the Commission has been persuaded by the foregoing arguments, and accordingly, has been willing to grant relief from Section 22(d) and Rule 22c1. ¹²

Section 17(a) of the 1940 Act provides that:

It shall be unlawful for any affiliated person or promoter of or principal underwriter for a registered investment company, . . . or any affiliated person of such a person, promoter, or principal underwriter, acting as principal (1) knowingly to sell any security or other property to such registered investment company . . . unless such sale involves solely (A) securities of which the buyer is the issuer, (B) securities of which the seller is the issuer and which are part of a general offering to the holders of a class of its securities, or (C) securities deposited with a trustee of a unit investment trust . . . by the depositor thereof; (2) knowingly to purchase from such registered company or from any company controlled by such registered company any security or other property (except securities of which the seller is the issuer).

Pursuant to section 2(a)(3) of the 1940 Act, a 5 percent or more holder of an ETF’s shares (5 percent holder) would be deemed to be an affiliated person of the ETF and, therefore, its transactions with the ETF would be subject to the provisions of section 17(a). As a result, to the extent that purchases and redemptions in kind of ETF shares are considered a sale of securities to the ETF by an affiliated person thereof within the ambit of Section 17(a), a 5 percent holder would be prohibited from purchasing and redeeming ETF shares.

In light of the foregoing, ETFs have applied for exemptive relief from section 17(a) to permit such affiliated persons of the ETF to purchase and redeem ETF shares. ETFs have argued that purchases and redemptions in kind effected by ETFs do not give rise to any of the concerns designed to be addressed by Section 17(a). In particular, they note that purchases and redemptions in kind are effected in exactly the same manner for all purchases and redemptions, regardless of size or number or the person’s status as an affiliated person. In addition, they point out that the method of valuing portfolio securities for purposes of calculating NAV is the same as that used for calculating the value of Deposit Securities and Fund Securities. The Commission has been willing to grant the requested relief from Section 17(a) based principally on the foregoing arguments.¹³.

Section 5(b)(2) of the Securities Act of 1933 (Securities Act) makes it unlawful to carry, or caused to be carried, through interstate commerce, any security for the purpose of sale or delivery after sale unless accompanied or preceded by a statutory prospectus. Although Section 4(3) of the Securities Act excepts certain transactions by dealers from the provisions of Section 5, Section 24(d) of the 1940 Act disallows such exemption for transactions in redeemable securities issued by a unit investment trust or an open-end management company, if any other security of the same class is currently being offered or sold by the issuer by or through an underwriter in a public distribution.

Because Shares are redeemable in Creation Unit size, are issued by an open-end management company and are continually in distribution, the above provisions require the delivery of a statutory prospectus prior to or at the time of the confirmation of each secondary market sale involving a dealer.

Certain ETFs have sought exemptive relief from section 24(d) of the 1940 Act to permit dealers in Shares to rely on the prospectus delivery exemption provided by Section 4(3) of the 1933 Act. They have argued in this regard, among other things, that ETFs are listed on an Exchange and their Shares are traded like common stock listed on an Exchange as well as shares of listed closed-end investment companies.

The Commission has granted exemptive relief from Section 24(d) to ETFs organized as UITs.¹⁴ In lieu of a prospectus, UIT investors receive a Product Description that is intended to briefly describe the UIT’s important features.

To date, however, the SEC has been unwilling to grant to ETFs, organized as open-end funds, any relief from prospectus delivery requirements in connection with secondary market transactions in Shares involving dealers.¹⁵

Section 22(e) of the 1940 Act provides that, subject to certain specified exceptions, redemption proceeds must be paid within seven days after a properly tendered redemption request. The seven day requirement presents difficulties for ETFs that invest in non-US markets with settlement cycles greater than seven days.

ETFs that encounter this problem have sought exemptive relief from Section 22(e) to permit extension of the seven day delivery requirement to a period consistent with the settlement cycle in the local market.

To date, the Commission has been willing to grant such relief, but only to the extent necessary to accommodate local settlement practices and holidays. Accordingly, detailed information respecting the settlement cycle in each market for which relief is requested and other information respecting settlement dates (including local holidays) is required in any application seeking 22(e) relief.¹⁶

Section 26(a)(2)(c), prohibits payments to the UIT’s sponsor, other than payments for administrative services. ETFs organized as UITs have obtained exemptive relief from this provision to permit the UIT to reimburse the UIT’s sponsor for certain nonadministrative expenses it incurs, including registration, marketing and organizational expenses. Such exemptive relief has, among other things, been subject to a representation that the sponsor will be reimbursed only for its actual out of pocket expenses.¹⁷

As indicated above, ETF Shares are continuously offered and are also traded in secondary markets. This combination gives rise to various issues under the Securities Exchange Act of 1934 (1934 Act).

Regulation M under the 1934 Act is a rule designed to prevent manipulation of the price of a security during the course of a distribution of that security. "Distribution" is defined as an offering of securities that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.¹⁸ Regulation M prohibits a distribution participant,¹⁹ in connection with a distribution of securities, from bidding for or purchasing from or attempting to purchase or induce any person to bid for or purchase such security.

Brokerdealers who tender Deposit Securities for Shares could, in certain circumstances, be deemed to be "distribution participants" within the meaning of Regulation M. To obviate the concern that Regulation M could be deemed applicable to purchases and redemptions of Shares, ETFs have sought relief from Regulation M or confirmation that various exceptions thereto are applicable.

The SEC Staff’s (Staff) view, in this regard, as reflected in recent noaction letters, is that the exception set forth in Rule 101(c)(6) of Regulation M, with respect to purchases and redemptions of shares of open-end investment companies ²⁰ and UITs,²¹ applies to transactions in the Shares.

ETFs have also sought relief from Regulation M to permit broker dealers to acquire securities for the purpose of accumulating the requisite Deposit Securities necessary to tender for Shares. To date, however, the Staff has not been persuaded that relief from Regular M should be extended for such purchases beyond the exceptions already reflected in Rule 101(b)(6) and Rule 101(c)(1) of Regulation M for "basket transactions" and "actively traded securities."²² These provisions except the following transactions: (1) transactions in which bids or purchases are made in the ordinary course of business in connection with a basket of 20 or more securities in which the security, subject to the distribution, does not comprise more than 5 percent of the value of the basket purchased; (2) adjustments to such a basket made in the ordinary course of business as a result of a change in the composition of a standardized index; and (3) transactions in "actively-traded securities," i.e., securities that have an average daily trading volume value of at least $1 million and are issued by an issuer whose common equity securities have a public float value of at least $150 million; provided however, that such securities are not issued by the distribution participant or an affiliate of the distribution participant.

Rule 14e5, among other things, prohibits a person who makes a cash tender offer or exchange offer for an equity security from purchasing, directly or indirectly, such security other than pursuant to the offer.²³ Rule 14e5 could be read as restricting the ability of a dealer manager of a tender offer for a particular security included in the ETF’s portfolio from purchasing and redeeming Shares during the offer period. That would be the case to the extent that purchases and redemptions of Shares are viewed as an indirect purchase or sale of the security subject to the tender offer. To obviate concerns in this regard, ETFs have sought, and the Staff has been willing to grant, exemptive relief from Rule 14e5 to permit dealer-managers to purchase and redeem Shares during the pendency of the offer.²⁴

ETFs have also sought relief from 14e5 to permit dealer managers to purchase shares of an equity security, subject to a tender offer or exchange offer, if made for the purpose of accumulating the requisite Deposit Securities necessary to tender for Shares. To date, however, the Staff has been unwilling to grant such broad based relief. The Staff’s view, in this regard, is that dealer managers are excepted from Rule 14e5 only with respect to purchases that satisfy the following conditions: (1) bids or purchases in the ordinary course of business, in connection with a basket of 20 or more securities, in which any security that is the subject of a tender offer or exchange offer, does not comprise more than 5 percent of the value of the basket; or (2) purchases effected as adjustments to such a basket in the ordinary course of business as a result of a change in the composition of the relevant index.

Rule 10a1 (Short Sale Rule) is designed to prevent the market price of a stock from being manipulated downward. Specifically, the Short Sale Rule prohibits short sales in securities unless effected at a price above the immediately preceding sale price (plus tick) or at the last sale price if such price was higher than the last different sale price (zero plus tick). ETFs have sought and obtained relief from the tick requirements of the Short Sale Rule.²⁵ The relief permits ETF Shares, unlike other exchange traded securities, to be sold short regardless of prior sale prices.

The Staff’s basis for granting such relief is that the ability to purchase and redeem ETF Shares at NAV should insure that the market price of ETF Shares will move in response to increases and decreases in NAV and that any temporary disparities between market prices and NAV should be closed through arbitrage activity. Accordingly, the Staff does not believe that the market prices of ETF Shares are susceptible to manipulation through short sales.

Rule 10b10 requires a broker dealer who effects a transaction on behalf of a customer, to provide the customer a written confirmation at or before completion of the transaction. The confirmation must contain certain specified information.

Compliance with Rule 10b10 would be extremely burdensome to the extent that all of its requirements were viewed as applicable to all securities comprising the basket of securities tendered or received in connection with a purchase or redemption of Shares. For this reason, ETFs have sought relief from the Staff to permit broker dealers to omit information respecting the identity, price and number of shares of each individual security tendered or received. The Staff has been willing to grant such relief conditioned upon the representation that the confirmation furnished by the broker-dealer to its customer will state that all information required by Rule 10b10 will be furnished upon request and all such requests will be fulfilled in a timely manner. ²⁶

A broker-dealer generally may not extend credit in connection with the purchase of any security that is part of a new issue if the broker dealer was a member of the selling syndicate within the prior thirty days.²⁷ Because ETFs are continuously offered as well as traded in the secondary market, the restrictions on margin in connection with purchases in a public offering could be viewed as applicable to ETFs. To obviate this concern, ETFs have sought and obtained no-action relief from the Staff to permit margin credit to be extended, in connection with the purchase of shares on an exchange, by broker dealers who engage exclusively in secondary market transactions in Shares. ETFs have also received confirmation that Shares may be treated by broker-dealers as shares issued by an open-end investment company and therefore be able to extend credit or maintain or arrange for the extension or maintenance of credit on Shares that have been owned for more than 30 days by the persons to whom credit is to be provided.²⁸

A broker-dealer is required, under Rule 15c5 under the 1934 Act, to disclose to its customers any control relationship between the broker-dealer and the issuer of the security being purchased or sold. Similarly, a broker-dealer that effects a transaction with a customer in connection with any distribution in which the broker-dealer is interested, is required, under Rule 15c16 under the 1934 Act, to disclose to its customer, the existence of such interest. ETFs have obtained no-action relief from the Staff to confirm that the foregoing rules do not require disclosure of a broker-dealer’s relationship with any issuer of a security held by the ETF.²⁹

Rule 10b17 requires a public company to give advance notice of certain specified actions (e.g. dividends). That rule does not, however, apply to redeemable securities issued by open-end investment companies. Because of the limited redeemability of ETF shares, it is not clear that the exemption for open-end investment companies is applicable. As a result, ETFs have sought exemptions from the requirements of Rule 10b17. The Staff has consistently granted these requests based primarily on the exemptive relief obtained by ETFs permitting them to register as open-end investment companies.³⁰

Section 13(d) requires beneficial owners of more than 5 percent of an issuer’s outstanding securities to file reports with the SEC. Section 16(a) requires each officer, director and beneficial owner of more than 10 percent of a public company’s outstanding shares (Insiders) to file reports with the SEC disclosing the number of shares beneficially owned, and reports regarding changes in ownership. The Staff has granted no action relief to ETFs with respect to the reporting obligations under Sections 13(d) and 16(a) to the effect that: (1) owners of more than 5 percent of the ETFs Shares are not required to file reports under Section 13(d); and (2) Insiders are not required to file reports under section 16(a).³¹

The no-action relief with respect to sections 13(d) and 16(a) is based primarily on representations that the ETFs Shares trade at prices that do not deviate materially from NAV. The letters caution, in this regard, that if the ETFs Shares begin to trade at prices that materially deviate from NAV, the no-action relief would no longer be available. The Staff will not consider future no action requests respecting sections 13(d) and 16(a) unless novel issues are presented.

Paragraph (c) of section 2830 of the Conduct Rules (Rules) of the National Association of Securities Dealers, Inc. (NASD) prohibits members who are underwriters of an investment company (Underwriters) from selling shares to any dealer or broker at a price other than that specified in the prospectus. Paragraph (g) of section 2830 of the Rules prohibits Underwriters from purchasing shares from the fund except for the purpose of covering purchase orders previously received or for its own account.

The purchase and sale of ETF Shares on an Exchange at market prices could be deemed to be violative of Section 2830(c) to the extent that transactions would be effected at prices other than that described in the prospectus. Similarly, the purchase and sale of ETF Shares at NAV could be deemed to violate Section 2830(g) to the extent that such transactions were effected for purposes other than covering existing purchase orders or for the Underwriter’s own account. In view of the foregoing, ETFs have sought confirmation from the NASD that the secondary market trading of Shares and purchases and redemptions of Shares would not be considered violative of Section 2830 of the Rules.

The NASD has been willing to grant the requested relief subject to the condition that the exemptive relief obtained by the ETF from the provisions of Section 22(d) of the 1940 Act and Rule 22c1 remains in effect.

There are currently no actively managed ETFs. While in theory, any type of managed fund could be structured as an ETF, formidable obstacles would have to be overcome in order to translate theory into reality. Issues that would need to be addressed include the following: (1) How would the basket of securities required to be tendered for purchase and redemption be determined? That is a relatively easy task in the case of index funds. It would be substantially more difficult in the case of a managed fund with a continually changing portfolio. (2) How would the value of a managed portfolio be calculated and updated continually throughout the trading day? (3) How would the foregoing information be disseminated without revealing a fund’s portfolio composition and/or securities that the fund has recently purchased or sold, or intends to purchase or sell? (4) Can the SEC be persuaded to grant exemptive relief that will effectively facilitate day trading of mutual fund like vehicles?

The ETF market is still in its infancy. While growth has been significant, mutual fund assets continue to dwarf those invested in ETFs. Obstacles to future growth include the complexity of the product and more importantly, the unavailability of ETFs other than index funds. The advent of actively managed ETFs could accelerate the growth rate of the ETF market enormously and, coupled with a continuing increase in investor awareness of ETFs as an investment alternative, ultimately enable ETFs to compete for investor dollars in a meaningful way with mutual funds.

1. See e.g., "The New Force in Funds," Money, February 2000, "Exchange Traded Funds Are the Hot Ticket Now," The New York Times, January 23, 2000.

2. The potential for actively managed ETFs is discussed under the heading "The Future—Actively Managed ETFs," infra.

3. See e.g., SPDRs®—which seeks to track the S&P 500; NASDAQ 100—Trust which seeks to track the NASDAQ 100; DIAMONDS (SM) which seeks to track the Dow Jones Industrial Average.

4. See e.g., Select Sector SPDRs®—which consists of 9 portfolios each of which seeks to track a particular sector within the S&P 500; WEBS, which consists of a number of separate portfolios each of which seeks to track a particular foreign securities index.

5. Most WEBS portfolios utilize sampling techniques.

6. Typically, an investor subject to a legal restriction with respect to a particular Deposit Security is afforded the opportunity, at the ETFs discretion, to deposit an equivalent amount of cash in lieu of such security.

7. A fixed transaction fee, payable to the fund, is applicable to each purchase transaction (regardless of size).

8. Unlike other ETFs, purchases and redemptions of WEBS are not effected through NSCC.

9. An investor subject to a legal restriction with respect to a particular Fund Security may be paid an equivalent amount of cash.

10. A fixed transaction fee, payable to the Fund, is applicable to each redemption transaction (regardless of size).

11. See e.g., In the matter of Select Sector SPDR Trust, 1940 Act Release Nos. 23534; November 13, 1998 (order) and 23492 (Oct. 20, 1998) (notice).

12. Id.

13. Id. The SEC has recently granted no action relief with respect to redemptions in kind effected by an open-end investment company with an affiliated person thereof. The relief is subject to a number of substantive and procedural conditions. Signature Financial Group, Inc. 1999 SEC No Act Lexis 981 (Dec. 28, 1999). The SEC Staff has not sought to extend the conditions of the Signature letter to the section 17(a) exemptive relief granted to ETFs.

14. See e.g., In the matter of DIAMONDS Trust et al., 1940 Act Release Nos. 22979 (December 30, 1997) (order) and 22927 (December 5, 1997) (notice).

15. A purchaser of Shares need not receive another prospectus in connection with a future purchase of Shares (unless the prospectus is supplemented or otherwise updated). As a practical matter, however, some brokerage firms may not be able to establish back office procedures to differentiate between new purchasers and purchasers who have already received a prospectus.

16. See In the matter of the Foreign Fund, Inc., et al., 1940 Act Release Nos. 21802 (March 5, 1996) (order) and 21737 (February 6, 1996) notice.

17. See e.g., DIAMONDS at note 14 supra.

18. Regulation M – Rule 100(b).

19. Id.

20. See e.g., NoAction Letter re Select Sector SPDRs (December 17 and 22, 1998).

21. See e.g., No Action Letter re NASDAQ – 100 Trust, Series 1 (March 3, 1999).

22. Id.

23. Rule 10b13 was recently redesignated as Rule 14e5. See Securities Act Release No. 7760 (Oct. 22, 1991).

24. See Select Sector SPDRs at note 20 supra.

25. Id.

26. Id.

27. Section 11(d) of the 1934 Act.

28. See Rule 11(d)1 under the 1934 Act.

29. See e.g., Select Sector SPDRs at note 20 supra.

30. Id.

31. See e.g., No Action Letter re Select Sector SPDRs (May 6, 1999).