Here’s what managers need to consider when embarking on their semi-transparent ETF journey.
Over the last decade, active asset managers have come under increased pressure as investors have shifted assets to lower-cost products, such as Exchange-Traded Fund (ETFs). The global ETF market has grown dramatically with assets under management eclipsing $6 trillion at the end of 2019, according to ETFGI. Active asset managers have been eager to find a way to leverage the ETF structure, but some have been reticent because they fear their investment strategy could be front run by the transparency of the structure.
US active managers may have finally found the answer they have been looking for, when the Securities and Exchange Commission (SEC) approved a raft of new semi-transparent ETF models. A semi-transparent ETF has most attributes of a traditional ETF but it doesn’t fully disclose its holdings daily. The SEC initially approved Precidian Investments’ ActiveShares® model in May 2019, followed by the approval of models by Blue Tractor, Fidelity, Natixis, and T. Rowe Price in November.
By removing the main barrier that has kept many active asset managers on the sidelines, the semi-transparent ETF could spark further growth of the ETF industry.
Why is this time different?
While there is excitement about the new options, this isn’t the first attempt at semi-transparent ETFs. The previous attempt wasn’t actually an ETF but rather a new fund structure, known as the Exchange-Traded Managed Fund (ETMF). The ETMF is a hybrid between a mutual fund and an ETF that allows for intraday trading but retains quarterly portfolio disclosures. However, unlike an ETF, investors trade the ETMF intraday without knowing the price of the fund. Instead, orders for the ETMF are placed throughout the day but not priced until the closing price of the fund is calculated, which means institutional investors can’t use the ETMF for trading purposes. In addition, the trades are placed with premiums for buys and discounts for sells, so retail investors bear extra trading costs for what is essentially a mutual fund.
“It’s different this time because the new models are actually ETFs,” says Stuart Thomas, Founding Principal at Precidian Investments. This will make it easier for distributors, advisors, and investors to understand the product. “While things might be different under the hood, from the investor’s perspective it is just an ETF,” Thomas notes. “With ActiveShares® there shouldn’t be a big learning curve for financial advisors or investors and the product should fit seamlessly into the ecosystem.”
The fact that they are ETFs should also make it easier for asset managers to adopt the product. “Once you’ve made the decision to create an ETF platform, upgrading to incorporate semi-transparent ETFs is a relatively minor lift,” Ed Rosenberg, Head of ETFs at American Century Investments notes. “ETF managers can consider expanding their product range to include semi-transparent ETFs without reinventing the wheel.”
Many Potential Paths
All of the approved models take slightly different routes to achieve semi-transparency. The ActiveShares® model leverages a new Authorized Participant (AP) Representative role that is independent from the AP and ETF, and uses confidential accounts owned by the AP, to buy and sell the ETF’s underlying securities on behalf of the APs. This additional step in the process changes how the APs interact with the market. Typically the AP helps ensure that the ETF’s market price stays in line with the underlying portfolio through the arbitrage mechanism of the creation/redemption process. With the ActiveShares® model, rather than delivering securities directly to the ETF, it will be done through the AP Representative.
Many of the other models use a proxy portfolio approach that would provide a daily view of a model portfolio, which should mimic the daily return of the ETF. However, there are subtle nuances to the various proposals. Under the Natixis model the proxy portfolio is reported on a lag from the actual portfolio and has a different composition and weighting. T. Rowe Price also utilizes a proxy basket on a lag but incorporates a 15 second indicative Net Asset Value (iNAV) to help with pricing. While the Fidelity model utilizes an optimized tracking basket that has similar exposures to the ETF’s portfolio. Blue Tractor’s approach publishes the portfolio daily but masks the actual weighting of the portfolio. Each of the semi-transparent solutions has benefits and it remains to be seen which one will become the preferred option for the industry. Though, it’s more likely that asset managers will use the solution that best suits their business model.
Major Semi-Transparent ETF Models
|ActiveShares® Precidian Investments||Shield Alpha ETFs℠ Blue Tractor||Active ETFs T.Rowe Price||Periodically-Disclosed Active ETFs Natixis||Fidelity ETF|
|Basket creation/ redemption||AP-owned confidential account at AP Representative||Proxy Portfolio – Dynamic SSR℠ Portfolio||Proxy Portfolio – Hedge Portfolio||Proxy Portfolio in partnership with NYSE||Proxy Portfolio – Tracking Basket|
|Share Pricing||Per share VIIV provided every second on actual portfolio holdings||Price determined by Dynamic SSR℠ portfolio Portfolio Price not dependent on VIIV||Price determined by Proxy Portfolio iNAV provided every 15 seconds||Price determined by Proxy Portfolio||Price determined by Tracking Basket|
|Holdings Disclosures||Before trading, fund discloses holdings to AP Representative and VIIV agent||Fund discloses names of all securities in portfolio, but not weighting||Fund discloses Proxy Portfolio daily||Fund discloses Proxy Portfolio daily||Fund discloses Tracking Basket and overlap daily|
|Full Portfolio Disclosure||Quarterly||Quarterly||Quarterly||Quarterly||Monthly|
How to Get There
Regardless of which approach is chosen, there are some key things that firms should consider when adding semi-transparent ETFs to their product line up. For managers launching ETFs for the first time, much of the ETF operating model will be familiar but there are ETF-specific nuances that must be taken into account. “The biggest organizational change when entering the ETF market is the need to establish a capital markets team,” according to Joe Rappa, Director of ETF Product Development at Citi Securities Services. “The capital markets team interacts with the brokerdealer and AP community to assist in the creation/redemption process, which is a critical function for ETFs.” Consideration should also be given to specialized ETF product and sales teams. Operationally, firms will have to determine how to integrate the creation/redemption basket process into their existing workflows.
All firms embarking on the journey to semi-transparent ETFs have some product-related issues to consider. Firms need to decide if they should launch new strategies that are tailored to best utilize the semi-transparent structure or simply replicate existing strategies. If the decision is the latter, then pricing needs to be considered. Semi-transparent ETFs are designed to lower the operating costs of active funds to better compete with passive funds. It could raise some eyebrows if a firm is offering the same strategy at two different price points, since the SEC has made this sort of pricing disparity a focus. With Regulation Best Interest due to come into effect in June 2020, financial advisors will be under pressure to ensure they are giving their clients the best option. Having a lower-cost option of an existing strategy could push financial advisors to move investors into semi-transparent ETFs, at the expense of the existing fund product. Though, managers may not necessarily need to lower management fees. “There is a general misconception that if you are offering a strategy in an ETF wrapper, the management fee needs to be lower,” notes Thomas. “Managers should focus on ensuring that the management fee is the same between wrappers and that operational cost savings result in better returns for investors.”
A Potential Shortcut
A potential solution to this dilemma is to convert an existing fund structure into a semi-transparent ETF. “Historically, the SEC has opposed mutual funds converting to an ETF structure,” notes Kelli O’Brien, Director of Fund Administration at Citi Securities Services. “However, having recently completed its ETF rules, which streamline the launch process creating faster speed to market, the SEC is now focusing on other issues in the ETF marketplace and has signaled a willingness to reconsider the idea.”
Regulatory considerations aside, the conversion to an ETF structure raises a number of tax, operational, and distribution issues. Perhaps the biggest operational challenge is with the transfer agent, which tracks and maintains the records of a mutual fund’s investors. When retail investors buy ETFs they purchase them on the secondary market, typically through brokerage accounts. “A traditional fund can have thousands of investors recorded as shareholders. ETFs are held electronically in the name of the depository,” Peggy Vena, Director of ETF Product Development at Citi Securities Services explains. “To convert a mutual fund to an ETF, managers would have to transfer the investors into brokerage accounts to issue shares of the ETF.” This would be a complicated process that could add cost and time to any potential conversion. Nonetheless, there continues to be interest in the concept and if the issues are worked out, it could be the cleanest way for active managers to enter the ETF age.
Long Road Ahead
Active managers will continue to face pressure from regulators and investors for lower-cost products. The advent of the semi-transparent ETF could be a game changer for the industry. Scott Livingston, Head of Global Product at T. Rowe Price explains, “While passive products have fueled the growth of ETFs in the past, we believe that actively-managed ETFs have the potential to gain traction with investors that are seeking active management but are interested in the efficiency of ETFs.”
Despite its potential, the transformation will not happen overnight. It will take time both for the market to develop and the preferred path to semi-transparency to emerge. Nonetheless, the growth of the ETF industry seems set to continue and active managers need to find a way to take advantage of this trend. The semi-transparent ETF may be just what the doctor ordered.