Everyone wants a safe and reliable vehicle. For example, if you're buying a car, it's a good idea to take a look under the hood. 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), a type of ETF built differently compared to traditional versions. That makes knowing what's "under the hood" of these instruments 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 these ETFs are basically structured the same way traditional mutual funds are, 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 newer types of ETF structures began receiving approval from the SEC in 2019. These 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 these new models is to make ETFs friendlier to active managers by removing the requirement that holdings be disclosed daily. For years, active managers have largely avoided ETFs,2 amid concern that providing daily full disclosure would allow traders to front-run their trades and for 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) the market makers and APs tend to conduct trades that keep the ETF's price generally in line with its underlying value. With active semi-transparent ETFs, daily disclosure of holdings isn't the standard.
As a result, these funds rely on other features to keep the fund trading smoothly. For example, one semi-transparent model uses an additional intermediary to facilitate creations and redemptions. Sort of like APs for the APs, authorized participant representatives (APRs) are the only entities other than the fund sponsor to know precisely what's inside the portfolio.3
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").
In some cases, the bid-ask spreads of active semi-transparent ETFs are higher than for traditional ETFs. This may be due to the fact that APs must employ new types of tools to efficiently value active semi-transparent ETFs, and many of the new active semi-transparent models appear to depend on a level of trust developing between the entities involved (APs, APRs, fund sponsors, etc.)
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. This could potentially reduce the tax efficiency of active semi-transparent ETFs compared to traditional ETFs and possibly create a drag on performance. However, for 2022, capital gains distributions (which result from sales made by the fund) were limited, with only seven semi-transparent ETFs distributing capital gains. Moreover, the Morningstar Tax Cost Ratio, which measures how much of a fund's annualized return is reduced by the taxes investors pay on distributions, shows little difference between the median Tax Cost Ratios of active semi-transparent ETFs and the traditional ETFs in the same Morningstar Categories.
Nevertheless, the range of investment strategies employed by active semi-transparent ETFs is limited, as the securities eligible for inclusion must be U.S. exchange-listed and trade during U.S. market hours.
While active semi-transparent ETFs may provide advantages compared to traditional mutual funds, it's important to remember that these ETFs have structural differences vs. traditional ETFs, and investors should proceed with caution.
A hybrid approach to investing:
- Mutual Funds
- Traditional ETFs
- Active Semi-Transparent ETFs
What is it?>Mutual FundsAn investment vehicle typically based on the Investment Company Act of 1940 that allows investors to pool assets and collectively purchase stocks, bonds, or other securities.>Mutual funds are either actively managed (investment decisions are based on the analysis of a single individual or investment team) or passively managed (the fund attempts to replicate a published index).Mutual funds typically disclose their holdings monthly or quarterly.Traditional ETFsAlso based on the Investment Company Act of 1940 (typically), but with significant exceptions to certain rules. For example, ETFs have received permission from the SEC to transact only with large, authorized participants (or APs) in big bundles of shares (typically 50,000).>Most ETFs disclose the holdings in their portfolios each day.While most traditional ETFs are passively managed, there are actively managed ETFs as well.Active Semi-Transparent ETFsNewer fund structures with additional differences vs. the Investment Company Act of 1940.Although the details and mechanics of these structures vary, the purpose behind all of them is to make ETFs more attractive to active managers by not revealing their funds' full, underlying holdings on a daily basis to market participants who may abuse such information.
Creation/redemption of shares>Mutual FundsInvestors buy or sell shares directly from the fund company (or through an intermediary, such as Schwab). Shares are created when the fund company receives investors' cash and issues shares to the investor at a price called the Net Asset Value (or NAV). The NAV is the end-of-day value of all the fund's assets minus its liabilities. All investors buying or selling on the same day receive the same NAV price.>Traditional ETFsOnly APs are able to transact directly with the fund company. Investors buy and sell shares from APs (and other market participants) on national stock exchanges throughout the trading day at prices which may differ from NAV.>Furthermore, most ETFs are created/redeemed "in-kind." To create shares, APs must deliver the securities comprising the fund's portfolio to the fund's sponsor in exchange for ETF shares. To redeem shares, APs deliver ETF shares to the fund sponsor and receive the fund's underlying holdings in return.Active Semi-Transparent ETFsCreation/redemption processes vary based on the exact terms of the structure; numerous structures have been proposed to the SEC and several have received SEC approval.>In most of the structures, the AP creates/redeems shares via a proxy portfolio (i.e., it delivers or receives securities that are not exactly the same as those actually held by the fund).However, in one structure, the creation basket contains the same holdings as the fund, but there is an additional intermediary between the fund sponsor and the AP.
Disclosure of full portfolio with actual holdings>Mutual FundsEither monthly or quarterly with a lag>Traditional ETFsTypically daily>Active Semi-Transparent ETFsEither monthly or quarterly with a lag>
Intraday calculation of portfolio value>Mutual FundsNot available>Traditional ETFsNo longer required by the SEC, but (when provided) typically calculated every 15 seconds; based on actual ETF holdings.>
Active Semi-Transparent ETFsVarious structures offer different calculation frequencies and are based on either the actual portfolio or a similar, proxy portfolio.>
Trading>Mutual FundsShares are bought and sold at end of day net asset value (NAV) directly with a fund sponsor.>Traditional ETFsShares are bought and sold on exchanges at market prices throughout the trading day.>Active Semi-Transparent ETFsShares are bought and sold on exchanges at market prices throughout the trading day. Because market makers and APs may be less able to accurately value the underlying holdings, shares may trade with wider bid-ask spreads and bigger premiums/discounts compared to traditional ETFs.>
Portfolio Management>Mutual FundsPortfolio managers may create capital gains when they buy or sell shares inside the portfolio to accommodate investors' cash flows. This can lead to lower tax efficiency.>Alternatively, holding cash to facilitate flows may reduce performance compared to a fully invested portfolio.Traditional ETFsMay use the creation/redemption process to remove lower-cost basis shares from the portfolio, which could increase tax efficiency.>Cash drag (the negative impact that excess cash can have on a company's or a fund's financial performance) is marginal due to receiving and distributing shares primarily in-kind.Active Semi-Transparent ETFsMay use the creation/redemption process to remove lower-cost basis shares from the portfolio, which could increase tax efficiency.>Cash drag is marginal due to receiving and distributing shares primarily in-kind. However, for structures which rely on proxy portfolios, managers 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. This could reduce the tax efficiency of active semi-transparent ETFs compared to traditional ETFs and possibly create a drag on performance.
Expense ratios>Mutual FundsNet expense ratios tend to be higher than ETFs, especially for actively managed mutual funds, which require research teams and tools (data packages, technology tools, etc.).>Traditional ETFsNet expense ratios tend to be lower, especially for funds tracking standard indexes in easy-to-access asset classes (e.g., U.S. large cap equities).>Active Semi-Transparent ETFsNet expense ratios tend to be higher, since these types of ETFs also require research teams and tools (data packages, technology tools, etc.).>
1 Final Rule: Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies, US Securities and Exchange Commission, February 27, 2004
2 Nate Geraci, "Can Nontransparent ETFs Save Active Mgmt?" ETF.com, June 13, 2019
3 "Precidian Comments on U.S. SEC Approval of ActiveShares™," Legg Mason, Inc. press release, April 8, 2019
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Active semi-transparent ETFs operate differently from other exchange-traded funds (ETFs). Unlike other ETFs, an active semi-transparent ETF does not publicly disclose its entire portfolio composition each business day, which may affect the price at which shares of the ETF trade in the secondary market.
Active semi-transparent ETFs have limited public trading history. There can be no assurance that an active trading market will develop, be maintained or operate as intended. There is a risk that the market price of an active semi-transparent ETF may vary significantly from the ETF's net asset value and that its shares may trade at a wider bid/ask spread and, therefore, cost investors more to trade than shares of other ETFs. These risks are heightened during periods of market disruption or volatility.
Schwab receives remuneration from active semi-transparent ETFs or their sponsors for platform support and technology, shareholder communications, reporting, and similar administrative services for active semi-transparent ETFs available at Schwab. This fee will vary, but typically is an asset-based fee of 0.10% per annum of the assets held at Schwab.
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