A Solution In Search Of A Problem?

Exchange-traded funds have become a big success story over the past quarter century thanks to their low costs, tax efficiency and ease of trading. In addition, the daily transparency of their holdings—unlike the quarterly reporting of holdings by mutual funds—is also considered one of their charms. Finally, and equally important, these (mainly) index-based products have ridden the wave of passive investing that has swept over the investing landscape like a tsunami.

Purveyors of actively managed, open-end mutual funds have watched with a mix of envy and fear as index-based ETFs have swooped up assets at their expense. They’ve been itching to get into the game by bottling their investment acumen into ETF form, but have remained on the sidelines for one big reason: They don’t want to show their hands by disclosing their holdings and portfolio weightings daily, as is required of ETFs. They fear that sophisticated investors will front-run their trades and copy their proprietary strategies.

That changed in early April when the Securities and Exchange Commission approved the ActiveShares structure created by Precidian Funds that enable actively managed ETFs that divulge their portfolio holdings on a quarterly basis. Precidian’s initial filing with the SEC was subsequently amended seven times before the regulator finally gave it the green light several days after its most recent amended filing. (As of press time for this article, that approval could be delayed if someone requested a hearing with the SEC by May 3.)

The ActiveShares structure has been licensed by a Who’s Who of asset management firms including BlackRock, Capital Group, JP Morgan, Nationwide, Gabelli, Columbia, American Century and Nuveen. Another licensee, Legg Mason, holds a minority equity position in Precidian Investments, a Bedminster, N.J.-based company that focuses on ETF and mutual fund development.

“A lot of the active managers have missed the ETF revolution, or I’ll call it evolution,” says Stuart Thomas, founding principal at Precidian Investments. “They discovered they needed to be able to take their best strategies and be agnostic about the vehicle in which they offer it. They know some people will buy only ETFs, and recognize they need to bring their strategies to an ETF format.”

Thomas believes that Precidian’s ActiveShares structure will be a conduit that encourages active investment managers to join the ETF party. “I think you’ll see relatively fast traction in a product like this,” he says. “You need the right managers and the right strategies.”

But if no one requests an SEC hearing and the ActiveShares structure is formally cleared for takeoff on May 3, don’t expect a flood of products based on that format to begin trading on May 4. This is a two-part process. Precidian cleared the first hurdle with its approval from the SEC’s Division of Investment Management. Next, an exchange has to file with the SEC’s Division of Trading and Markets to list these products.

Along with Precidian, other companies seeking approval for ETF structures designed to let active managers launch ETFs without daily portfolio disclosures include giant asset managers T. Rowe Price and Fidelity Investments, along with Blue Tractor Group and Natixis Investment Managers, in a joint filing with the NYSE. Blue Tractor and Natixis, like Precidian, aim to license their respective structures to unaffiliated fund sponsors.

Collectively, these various structures are referred to as non-transparent ETFs. Thomas bristles at that designation. “I don’t like that term at all,” he says. “We’re not showing the portfolio constituents on a daily basis, but we’re doing it at the same frequency as mutual funds, and they’re not called non-transparent.”

NAV Is Key

Reading about how these non-transparent structures work makes the eyes glaze over. Frankly, they’re wonky and complicated. Then again, the inner workings of traditional “transparent” ETFs are a little complicated, too.

Here’s what’s at stake with so-called non-transparent structures, and why they’ve had a tough time getting approved by the SEC:

The designers of these structures are seeking what Precidian received: exemptive relief to bring ETFs to market. Not all aspects of ETFs are consistent with the requirements of the Investment Act of 1940 that governs open-end funds. Which means ETF providers must go to the SEC’s Division of Investment Management to file for exempted relief from ’40 Act provisions dealing with redeemable securities, trading only at net asset value, and fund transactions by affiliated persons.

Open-end mutual funds are bought and sold at the end of the trading day at a price based on their net asset value, which is calculated after the markets close. ETFs, on the other hand, trade in the secondary market throughout the day on stock exchanges. The secondary market is where investors buy and sell securities from one another. ETFs are required to have a mechanism in place to ensure their shares trade at a price that is at or close to the NAV per share of the ETF.

ETFs are able to do this through a creation-and-redemption process. In simple terms, that involves authorized participants—known as APs, which are typically a market maker, specialist or large institution such as a broker-dealer—that buy securities in the primary market (where new securities are created) that a particular ETF wants to hold and bundles them into a basket of securities. The AP then delivers this bundle to an ETF sponsor. In turn, the ETF sponsor creates the ETF shares, known as a creation unit, and gives them to the AP who delivers them to the secondary market for trading.

On the flip side, if there’s low demand for the ETF shares in the secondary market, an AP can buy them and create a redemption unit that is delivered to the ETF sponsor in the primary market. The sponsor redeems the shares for individual securities that make up the shares and gives those securities to the AP, who can sell them in the open market for cash. 

This rinse-and-repeat creation/redemption cycle provides arbitrage opportunities that make for a liquid market and help ETFs trade at or near their net asset value. (It also accounts for the tax efficiencies of ETFs because the “in kind” transactions between ETF sponsors and APs means there are no capital gains.)