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.
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 some actively managed ETFs as well.Active Semi-Transparent ETFsNew fund structures with additional differences vs. the Investment Company Act of 1940.>Although the details and mechanics of each new structure 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 new structure; numerous structures have been proposed to the SEC and several have received SEC approval. In most of the new 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 ETFsTypically available every 15 seconds; based on actual ETF holdingsHowever, dissemination of intraday portfolio value is not required by the SEC’s 2019 ETF Rule. So, this practice may be discontinued for at least some (and perhaps many) ETFs.9>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. However, trading to date has been in line with other ETFs in the same asset class and with similar fund sizes.>
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 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.). However, the expense ratios for the active semi-transparent ETFs which have launched are on par with the lowest cost share classes of similar funds offered by the same fund sponsor (the lowest cost share classes are often referred to as “institutional share classes”).>
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
4 SEC File No. 812-14405, dated April 4, 2019
5 Kramer, N., and Kayl, C., “Non-Transparent Exchange Traded Products: A Revolution 25 Years in the Making,” ALPS Inc., October 31, 2019
6 SEC File No. 812-14405, dated April 4, 2019
7 DaveNadig, “The 6 Year Active ETF Solution,” ETF Report, July 15, 2019
8 Diana E. McCarthy, Veena K. Jain, Joshua M. Lindauer, “SEC Approves First Nontransparent, Actively Managed ETFs,” The National Law Review, April 17, 2019
9 Thomas Ahmadifar, Alexandra Kambouris Alberstadt, Todd P. Zerega, “The SEC Issues its Long Awaited ETF Rule (Part 2) – What was Omitted,” PerkinsCoie Asset Management ADVocate, September 30, 2019