What’s in a name? What’s in a fund structure? These two questions come into play regarding the expected rollout of exchange-traded funds based on the ActiveShares structure created by Precidian Funds that enable actively managed ETFs to divulge their portfolio holdings on a quarterly basis like mutual funds do, rather than on a daily basis like traditional ETFs must do.

The ActiveShares concept was approved by the Securities and Exchange Commission in May, and it’s the first to get the thumbs up from among several other entities that have approached the regulator in recent years seeking approval to roll out a structure letting active managers launch ETFs that don’t have daily portfolio disclosures. Those other platforms from the likes of T. Rowe Price, Fidelity Investments, Blue Tractor Group and a joint effort by Natixis Investment Managers and the New York Stock Exchange are still under review.

These product structures were initially labeled as "non-transparent" by the media and others, but Precidian calls them "semi-transparent" because it says ActiveShares funds provide the same quarterly portfolio transparency as mutual funds, which aren’t called non-transparent.

Ben Johnson, Morningstar’s director of global exchange-traded fund research, prefers the term “less-transparent” exchange-traded products.

Either way, the premise behind the perceived need for ActiveShares and the other non/semi/less-transparent fund structures is that active managers have been reticent to put their actively managed investment strategies into ETFs because they fear that showing their portfolios on a daily basis will let sophisticated investors front-run their trades and copy their proprietary strategies. As such, active management comprises just a tiny portion of the overall $4 trillion U.S.-listed ETF market, and the bulk of those assets are tied to fixed income. 

Precidian CEO Dan McCabe believes his company’s methodology opens the door for active equity managers to join the ETF party.

“The active management community has been frozen in a vehicle that was established in 1940 until the recent approval of this Active Shares structure, which will allow asset managers to come to market with products that protect their intellectual capital," he says. “Prior to this, they weren’t willing to take their intellectual property and make it transparent.”

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

Just last week, asset management firm Alger said it entered into a licensing agreement with Precidian to introduce growth equity strategies as semi-transparent ETFs in 2020.

JP Morgan estimates that about $7.2 trillion in mutual fund strategies could be applied to funds based on the ActiveShares format, according to Bloomberg News. The first ActiveShares ETFs are expected to hit the market later this year or in first quarter 2020.

How It Works

ETFs are required to have a mechanism in place to ensure their shares trade at a price that is at or close to the net asset value per share of the ETF. They’re able to do this through a creation-and-redemption process 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.

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 creation/redemption cycle provides arbitrage opportunities that make for a liquid market and help ETFs trade at or near their net asset value. And this pricing mechanism depends on daily portfolio transparency that enables market participants to effectively assess whether an arbitrage opportunity exists. 

With ActiveShares ETFs, the structure relies on a “trusted agent,” or AP representative, who would know the portfolio holdings and use a confidential account to perform all creations and redemptions on behalf of an AP. In addition, these funds operate similar to traditional ETFs by quoting a consistent intraday indicative value that reflects the value of a particular fund’s portfolio holdings. But rather than calculating that intraday indicative value every 15 seconds like existing ETFs do, the verified intraday indicative value for ActiveShares funds will be calculated every second during the trading day.
 
This is how ActiveShares are designed to maintain a price that is at or close to the NAV per share of an ETF without daily portfolio disclosures.

“We’ve created an active management vehicle that can compete with passive managers,” McCabe says.

Investor Demand?

The push by Precidian and others seeking to roll out structures enabling actively managed ETFs with limited transparency is predicated on the belief that investors want active management in the ETF space. Indeed, the growing preference for passive management has fueled the ETF industry’s massive growth during the past quarter century, and it remains to be seen whether ETF investors are itching to invest in strategies employed by active mutual funds given the perception—some of it warranted, depending on the asset class—that active managers have had a hard time beating their bogeys.

“I did a quick data poll shortly after Precidian got approval for the ActiveShares structure, and if you look at flows across funds currently managed by Precidian licensees that in theory would be able to be delivered through the ActiveShares format, we’ve seen billions of dollars in cumulative outflows from these funds,” says Morningstar’s Ben Johnson.

In other words, investment managers worried about asset flight from their mutual funds hope that packaging their active strategies into semi- or less-transparent ETF platforms created by Precidian and others will stanch the losses and bring assets back to the fold.

Perceived—or real—underperformance by active investment managers, combined with higher fees found in mutual funds, have played into the hands of the ETF space. At the very least, asset managers will save money by putting their strategies into ETFs because these products have cheaper administrative costs than mutual funds, which should result in lower-cost products versus comparable mutual funds. But they will still need to pay for research teams and portfolio managers to pick securities, which costs more than licensing an index to track.

This summer, fintech firm Broadridge teamed up with Q8 Research to survey 200 financial advisors across various channels who have at least $10 million in assets under management to see how potentially receptive they are to the ActiveShares structure. At the time, there wasn’t a strong awareness about the platform among respondents. Nonetheless, 64% of advisors said they’re likely to use an ActiveShares product only after it’s available for 12 months, while 22% said they’re likely to use them within the first 12 months. Fifteen percent said they likely won’t use them at all.

Perhaps more telling, 63% of advisors said they would most likely draw assets away from mutual funds if they invested in ActiveShares ETFs.

And as far as existing semi-transparent ETP formats go, investors haven’t warmed up to the exchange-traded managed funds structure licensed by NextShares Solutions LLC, a unit of Eaton Vance Corp. NextShares funds are actively managed products that report their holdings quarterly and trade during the day relative to their end-of-day net asset value. These products first launched in 2016 and on the whole haven’t been embraced by investors, in part because they have poor distribution.

The other existing exchange-traded product structure that doesn’t have daily portfolio disclosures belongs to Vanguard, the second-largest ETF issuer, whose index-based ETFs disclose their portfolio holdings monthly with a 15-day lag. The lack of daily portfolio transparency clearly hasn’t hurt Vanguard’s ability to gather assets.

Regarding Precidian’s ActiveShares structure, the firm had to revise its initial filing with the SEC seven times before it was finally approved this spring. It was a long, hard slog for Precidian, but now its creation is ready for prime time.

“We didn’t think it would take this long, but we didn’t think we were going to give up, either, because we sincerely thought this was the right answer,” McCabe says. “So it was worth the battle.”