Are you ready to invest in actively managed exchange-traded funds from the likes of Fidelity Investments, T. Rowe Price and other leading asset managers who’ve made names for themselves in the actively managed mutual fund space? After a yearslong process that involved filing initial applications—and refiling multiple amended applications—with the Securities and Exchange Commission, Fidelity and T. Rowe Price recently got a green light from the regulator to roll out actively managed ETFs that aren’t required to have daily portfolio disclosures like traditional ETFs do.

In one fell swoop, the SEC in late autumn cleared the deck when it approved applications for launching so-called semi-transparent ETFs from those two firms and two other entities—Blue Tractor Group and a joint effort by Natixis Investment Managers and the New York Stock Exchange, both of which had applications before the SEC that were amended multiple times before being approved.

This follows the SEC’s approval this spring of a semi-transparent structure for actively managed ETFs created by Precidian Funds that has been licensed to a gaggle of leading asset managers including BlackRock, Capital Group, J.P. Morgan, Nationwide, Gabelli, Columbia Threadneedle, American Century, Nuveen and Legg Mason.

This is huge for the ETF industry because the market will likely soon be flooded with new actively managed equity products from asset managers who previously were reluctant to put their actively managed investment strategies in an ETF wrapper over fears that showing their portfolios daily would let sophisticated investors front-run their trades and copy their proprietary strategies.

Sure, BlackRock’s iShares unit is already the largest U.S. ETF sponsor, but aside from four active ETFs, the rest of its product suite of roughly 350 ETFs is passive. And some of the other firms mentioned above (including Fidelity) also have ETFs on the market, and a small number of them are actively managed. But all of these firms have actively managed equity strategies in mutual funds they believe could work in the ETF world—provided they can protect their secret sauce.

These asset managers want to take advantage of the benefits offered by the ETF structure in the form of lower costs and greater tax efficiency. They also want to join the ETF revolution because they’re tired of seeing money flow out of their mutual funds and into ETFs, where total assets are roughly $4.3 trillion and rising.

But are investors—and financial advisors—jonesing for actively managed ETFs with limited transparency? And do investors even care about transparency? After all, they invest trillions of dollars in mutual funds with limited—usually quarterly—portfolio disclosures.

As noted in an industry alert from the law firm Ropes & Gray, these semi-transparent models employ various methods to create “proxy portfolios” where there’s some transparency for ETF holdings and baskets available to authorized participants and other market participants responsible for setting prices for these securities.

“Broadly speaking, they’re all designed to protect some portfolio information while providing transparency through other mechanisms,” says Brian McCabe, who follows the ETF space as asset management partner at Ropes & Gray. He adds that ETF transparency likely matters much more to the ETF industry than to investors.

But that takes us back to the question of whether investors want actively managed ETFs. After all, the growing preference for passive management has fueled the ETF industry’s massive growth during the past quarter century. This growth was powered both by the cheaper expense fees typically offered by ETFs, along with the growing perception that active managers on the whole consistently underperform their bogeys.

Actively managed exchange-traded products (including both ETFs and exchange-traded notes) represent only about 2% of U.S.-listed exchange-traded product assets under management, according to Morningstar Direct, which says these products have an average expense ratio of 0.67%. That’s higher than typical passive ETF ratios, but lower than the cost of traditional active equity mutual funds.

Too Late To The Party?
iShares, Vanguard, State Street, Invesco, Charles Schwab and other leading providers of index-based ETFs have seemingly cornered the market for low-cost passive products. But some industry watchers believe that creates an opening for actively managed products, particularly on the equity side.

“I think there’s still plenty of room for growth because there’s a limited amount of actively managed equity ETFs,” says Grant Engelbart, senior portfolio manager and research director at CLS Investments, which constructs portfolios and manages ETF strategies for the advisor clients of its parent company, Orion Advisor Solutions.

“The likes of T. Rowe, Fidelity, BlackRock, Capital Group, J.P. Morgan and all of the other names involved in the semi-transparent active ETF space have such powerful sales forces and are bringing that to a structure [ETFs] that’s cheaper from a cost and tax perspective, so I think there’s a huge runway for these products,” he adds. “Particularly when you look at the strong U.S. equity market this year and the preliminary capital gains payouts I’ve seen, I think investors will look for opportunities for a more efficient structure, and I think this will provide that for them.”

Regarding asset allocation, many financial advisors use ETFs as cheap beta to fill the core positions in client portfolios and complement that with satellite positions in active equity mutual funds or thematic ETFs to generate alpha. Engelbart offers that active, semi-transparent equity ETFs could be a logical replacement for equity mutual funds in portfolios. “It’s unlikely that super-cheap beta funds will be replaced by actively managed funds,” he says.

Cannibalization
But if people, say, dump a Fidelity equity mutual fund in favor of a similar strategy found in a Fidelity ETF, that’s potentially a case of robbing Abbott to pay Costello. In other words, will asset managers be running to stand still on the asset front if investors dump their mutual funds in favor of cheaper ETFs?

Tim Coyne, new head of ETFs at T. Rowe Price, doesn’t fear that new ETFs will cannibalize the company’s existing mutual fund franchise. “I look at this as being additive to the business, and it’s going to be great for our clients and the firm,” says Coyne, who joined T. Rowe Price in October after spending the past 13 years at SPDR ETFs, where he most recently was global head of capital markets. “It will put us in a position where we can expand upon our product set and potentially reach new clients. There are certain clients who have gravitated more toward the ETF structure, and having ETFs gives us an additional way to enable investors to access T. Rowe Price’s investment capabilities through their product of choice.”

Coyne notes there could be some strategy overlap between existing mutual funds and new ETFs. “We’re looking at both existing strategies and potential new strategies,” he says.

But some ETF participants say cannibalization could be a real threat for asset managers, particularly if they plan to simply repackage existing mutual funds into new ETF wrappers. “There is a risk,” says Shawn McNinch, managing director of investor services at Brown Brothers Harriman, which does ETF-related custody and administration work. “I talk to ETF managers and sponsors, which gives me insights into their strategies. At the macro level, while their initial read might be, ‘Hey, I’ll just clone this product,’ I think when they start peeling back the onion they find more obstacles and challenges if they just want to clone their product and what that might mean for cannibalization. I think the vast majority of asset managers coming out with active, semi-transparent strategies will have different products and [are] not really cloning their existing mutual funds.”

Winning The Hearts And Minds
Asset managers planning to roll out actively managed, semi-transparent ETFs will need to crack the financial advisor market to be successful.

Three things could work in their favor. One is cost: ETFs have cheaper administrative costs than mutual funds, which should result in lower-cost products. And then there’s the tax efficiency of ETFs derived from the structure’s creation/redemption process, which typically eliminates capital gains distributions. Third, the companies associated with this potential new wave of ETFs have long track records and come with built-in brand equity that could score points with investors, financial advisors and the investment platforms that serve advisors.

“Realistically, it will come down to their large sales forces,” says Engelbart from CLS. “Education will be big, and semi-transparent ETFs will have both a strategy and a product structure people will need to be educated about. And there are five structures out there with differences in how they’re constructed. All of this is a brand new conversation beyond simply ‘This is an ETF, and this is how it works.’”

At the end of the day, McNinch believes transparency is basically a non-issue for most investors. “Investors are buying the strategy and the name of the asset manager’s brand. If I can have an active strategy at a lower expense ratio, that’s more tax-efficient than a mutual fund just because of the structure, I think that’s good for investors. That’s why I’m bullish on these structures and what they mean to the investor community,” he says.

McNinch says activity from product sponsors indicates that a slew of actively managed semi-transparent ETFs could hit the scene in 2020. If so, that could be the industry’s big story line of the year. The other big story line could be whether investors ultimately buy these products.

Four Proxy-Based Semi-Transparent ETF Structures

Blue Tractor Shielded Alpha
Blue Tractor’s Shielded Alpha discloses the securities that are in the actual fund each day, but won’t provide their individual weightings. Each day a proprietary algorithm will generate a proxy portfolio that has at least 90% overlap with the fund’s portfolio. Full profile disclosure: Quarterly, with 60-day lag

Fidelity
Fidelity’s proxy, called a tracking basket, consists of underlying fund holdings, ETFs and cash. The tracking basket will be derived through a proprietary optimization process, and the overlap between the fund and the tracking basket will be published to the fund’s website daily. Full profile disclosure: Monthly, with a 30-day lag

Natixis/NYSE Periodically-Disclosed Active ETF
Periodically-Disclosed Active ETFs allow for efficient trading of ETF shares through a proxy portfolio methodology owned by the NYSE. This methodology will employ a factor analysis of each ETF and its corresponding universe of eligible securities to create the proxy portfolio. The ETF’s proxy portfolio will closely track the actual portfolio and may change daily. The ETF will use a proprietary software developed by analytics company Axioma to allow market participants to assess the intraday value and associated risk of a fund’s portfolio. Full profile disclosure: Not addressed; presumed quarterly with 60-day lag

T. Rowe Price
T. Rowe Price’s proxy comprises a basket of cash and securities designed to closely track the daily performance of the fund’s portfolio. In addition to the proxy portfolio, each business day before the start of trading the fund will publish the portfolio overlap, tracking error and the deviation between the proxy and fund NAVs on a daily and rolling one-year basis. Full profile disclosure: Quarterly, with 60-day lag

Sources: Brown Brothers Harriman (“New Wave of Active ETFs Shield the Secret Sauce” report); Ropes & Gray (Non- or Semi-Transparent Active ETF Developments industry alert)