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This article was authored by Jay B. Gould, Ildiko Duckor, Clint A. Keller and Michael G. Wu of international law firm Pillsbury:

In recent years, many hedge funds have significantly increased their holdings in exchange-traded funds (ETFs). Historically, hedge funds primarily acquired short positions in ETFs to hedge their long positions in a particular industry segment by obtaining short exposure to an entirely different industry segment. However, many hedge funds are now acquiring long positions in ETFs as part of their core investment strategies. Hedge funds and their managers should be aware that substantially increasing their long positions in ETFs could result in such hedge funds violating the ownership limit set forth in Section 12(d)(1)(A)(i) of the Investment Company Act of 1940 (the Investment Company Act). Although Section 12(d)(1)(A)'s limitations apply to investments in any registered investment company, including closed-end funds, the discussion below focuses on ETFs due to their popularity as a component of the investment strategies of hedge fund managers.

Current Regulations Affecting a Hedge Fund's Ability to Acquire Shares of an ETF Under the Investment Company Act, private investment funds (e.g. hedge funds) are generally prohibited from acquiring more than 3% of an ETF's shares (the 3% Limit). In order to allow purchases of their shares in excess of the 3% Limit, many ETFs have sought exemptive relief from the Securities and Exchange C......................

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