Active Semi-Transparent ETFs: What's Under the Hood?

Everyone wants a safe and reliable vehicle. So, when buying a car, experts recommend that it's a good idea to pop the hood and take a look inside. What you see may tell you a lot about the vehicle's performance, cost and reliability for years to come. The same is true for active semi-transparent exchange-traded funds (ETFs). This is a new type of ETF that is built differently from a traditional ETF. Therefore, knowing what's under the hood is more important than ever.

Most ETFs on the road today are based on the '40 Act fund chassis (referring to the Investment Company Act of 1940). This means that they're basically structured in the same way that traditional mutual funds are structured, but their sponsors have received permission from the U.S. Securities and Exchange Commission (SEC) to do things a little differently. For example, traditional '40 Act mutual funds buy and sell shares at the end of each trading day, with investors of all sizes, at the fund's net asset value (NAV). ETFs, on the other hand, have received permission from the SEC to transact only with large authorized participants (APs) in big bundles of shares (typically 50,000). Another difference between ETFs and mutual funds is the frequency of portfolio disclosure. While mutual funds typically disclose their holdings either monthly or quarterly with a significant lag (up to 60 days), most ETFs disclose complete holdings information every day the markets are open.¹

Historically, most ETFs have operated with similar exemptions from the Investment Company Act of 1940, but new types of ETF structures began receiving approval from the SEC in 2019. These new ETF models are frequently referred to as "active semi-transparent," and the first ETFs based on these models were launched in 2020. Although the details vary, the purpose behind all of these new models is to make ETFs friendlier to active managers by removing the daily disclosure of holdings. For years, active managers have largely avoided ETFs,² because they've been worried that providing daily, full disclosure would allow traders to front-run their trades and competitors to steal their "secret sauce."

However, daily disclosure has been a very important component of ETF mechanics. Knowing exactly what's inside an ETF allows market makers and APs to efficiently value the portfolio and (for most large, liquid ETFs) they tend to conduct trades that keep the ETF's price generally in line with its underlying value.

Because completely transparent, daily disclosure of holdings doesn't come standard, active semi-transparent ETFs must offer a package of other features to keep the fund trading smoothly. For example, Precidian's ActiveShares structure uses an additional intermediary to facilitate creations and redemptions. Sort of like APs for the APs, authorized participant representatives (APRs) are the only entities outside of the fund sponsor to know precisely what's inside the portfolio.³ 

When an AP wants to create shares, the AP contacts an APR, who buys the stocks in the creation basket on their behalf within a confidential account and delivers those securities to the ETF's manager in-kind. In return, the ETF manager delivers ETF shares, which the APR passes back to the AP. Conversely, when an AP requests a redemption, the APR receives the ETF's redemption basket (underlying securities) from the fund sponsor, sells the securities within the confidential account, and then delivers the proceeds to the AP. In either case, the AP does not know exactly which stocks were bought or sold on their behalf.⁴ 

To help APs manage this new creation/redemption process, the ActiveShares model provides more frequent snapshots of a fund's value. Currently, the intraday indicative value (IIV) is calculated by exchanges for traditional ETFs every 15 seconds,⁵ while ETFs based on Precidian's ActiveShares structure provide a real-time snapshot every second.⁶

The SEC has also approved other active semi-transparent ETF models, which don't employ additional intermediaries, but instead rely on creation/redemption baskets that are slightly different from a fund's actual holdings. These proxy portfolios may include decoy securities and/or alternative weighting schemes, and they are frequently generated with the assistance of computer programs (typically described as algorithms or mathematical optimizations).

Because APs may not be able to use their current tools to efficiently value ETFs and trade them smoothly, and many of the new models appear to depend on a level of trust developing between the entities involved (APs, APRs, fund sponsors, etc.), it's possible that transaction costs for active semi-transparent ETFs could be higher than for traditional ETFs, at least initially.^7,8 However, based on their limited track records so far, semi-transparent ETFs appear to be trading in line with other ETFs in the same asset class and with similar fund sizes. 

Furthermore, tax efficiency could be a concern for models that rely on proxy portfolios, since the ETF's manager will have to buy and sell securities to better align the securities they receive through creation/redemption baskets with the securities they actually want to own. Potentially, this could reduce the tax efficiency of active-semi-transparent ETFs compared to traditional ETFs and possibly create a drag on performance. However, for 2020, capital gains distributions (which result from sales made by the fund) were limited, with only one semi-transparent ETF distributing capital gains.

Nevertheless, the range of investment strategies employed by active semi-transparent ETFs is limited (at least initially), as the securities eligible for inclusion must be U.S. exchange-listed and trade during U.S. market hours.

Finally, while active semi-transparent ETFs may provide advantages compared to traditional mutual funds, it's important to remember that none of the new models have been truly crash-tested. Simulating a market environment that suddenly becomes irrationally volatile or where liquidity quickly dries up just isn't possible for new financial products in the same way that simulating a wet or icy road is for vehicles. As a result, we believe that active semi-transparent ETFs are an interesting development, but until these funds have a longer track record, most investors should proceed with caution.