After 10 years of waiting, non-transparent and semi-transparent ETFs are finally hitting the market. On December 10, 2019, the SEC gave approval for four new ETF structures (for a total of six) that don’t require daily disclosure of holdings.
Why are the New ETF Structures Important?
The ETF industry has exploded over the last decade (into a nearly $4 trillion market), but most actively managed strategies have not contributed to this growth.1 In fact, actively managed ETFs account for less than one percent of the overall assets in ETFs, and most of that is in fixed income products.1
While ETFs boast a number of benefits over mutual funds (improved tax efficiency, lower cost structure, and the ability to intra-day trade, to name just a few), the daily transparency of holdings requirement has kept active managers away. Their rationale is typically that what, when, and how much they buy is their “secret sauce,” and if their holdings are on full display all day, every day, their strategy might be front-run or replicated.
How Do These New ETFs Work and Will Active Equity Managers Flock to Them?
There are a number of versions of these structures, but they will all basically have a representative proxy basket that hides the underlying holdings, which will be disclosed once a quarter, with a lag time between 15 to 60 days. The baskets will contain enough detail so that Authorized Participants (APs), generally large banks, can efficiently trade the portfolio and hedge their exposure, without disclosing the actual holdings.
So, now that active managers can put these new vehicles into action, why wouldn’t all of them adopt active ETFs? Well, a number of large firms (American Century, Fidelity, Invesco, Natixis, and T. Rowe Price) have already applied to launch some of their actively managed mutual funds in the ETF structure. Other firms are taking a wait-and-see approach but will likely enter as the initial kinks get worked out.
What I’m Watching
Success for this new structure of ETFs will hinge on confidence that they will work as advertised. As these products launch, here is a list of things I will be watching for:
- Trading Spreads: Will the APs have enough information to create and redeem the portfolios efficiently – and with tight enough spreads to satisfy buyers and sellers?
- Platform Adoption: How quickly will platforms add these products to their rosters? Many platforms have minimum track record and asset minimum requirements. Will they take mutual fund assets in the strategy into account?
- Conversions: Will investors be able to easily move from an existing mutual fund into its active ETF cousin? Are in-kind transfers an option or will it be a fully taxable event?
- Track Records: Will a mutual fund’s track record align with these new products or will performance have to start from scratch?
Ultimately, I believe that the lower cost structure and tax efficiency of active ETFs, when compared to mutual funds, will drive actively managed assets to this new structure. Adoption will likely be rapid, as distribution teams won’t have to execute basic education on ETFs. Time will tell if these new ETF structures will live up to the hype.
1. Nate Geraci, “Can Nontransparent ETFs Save Active Mgmt?,” ETF.com, last modified on June 13, 2019, https://www.etf.com/sections/etf-strategist-corner/can-nontransparent-etfs-save-active-mgmt.
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