Is the Market Ready for a Non-Transparent ETF?

Mainstream investors have overwhelmingly embraced passive Exchange Traded Funds (ETFs) as highly efficient tools for achieving targeted exposures with the benefits of liquidity, transparency, low cost and tax efficiency. But now that the passive U.S. industry appears to be reaching maturity, some product sponsors are questioning whether there is a value proposition for active management wrapped in an ETF structure.

Actively managed non-transparent ETFs have the potential to add real value for investors. Lower expense ratios and greater tax efficiency will theoretically yield higher total returns relative to a comparable mutual fund structure. Their non-transparency, however, may pose an obstacle for investors.

An evolution

In 1990, Harry Markowitz won the Nobel Memorial Prize in Economic Sciences for his contributions to Modern Portfolio Theory (MPT). Shortly thereafter, the first exchange traded fund, tracking the S&P 500 index, debuted in 1993.

It’s no coincidence that the proliferation of ETFs has mirrored the evolution of MPT, which espouses a risk-return based approach to constructing portfolios. Index ETF products emerged as advisors began customizing asset allocations to achieve an optimized risk-return profile for their clients.

Exchange Traded Products (ETPs) have evolved over the years. From their launch as simple index products, ETPs have now transformed into fundamentally weighted, alternative, leveraged and currency-oriented funds. The only unchecked box appears to be actively managed ETFs structured to produce excess returns.

With the passive U.S. industry reaching potential maturity, is there a value proposition for active management wrapped in an ETF structure?

Potential hurdles

While actively managed transparent ETFs are available in the U.S., their growth has been limited to a few fixed-income managers. Few advisors are willing to give away the intellectual property that underpins their strategies, which is understandable. The majority of equity-based, actively managed shops, hesitant to launch products, continue to remain on the sidelines, focusing their attention instead on open-ended mutual funds.

The biggest obstacle to this effort is the intraday tradability feature of ETFs. ETFs are transparent vehicles that allow secondary market trading to closely track the ETF’s intrinsic Net Asset Value (NAV). If a significant enough disconnect occurs between the price of the ETF and its underlying securities, a broker can quickly arbitrage the difference by exchanging a basket of the ETF’s underlying securities for ETF shares.

This transparency and natural arbitrage mechanism is essential for investors who are depending on receiving fair value on their trades. Non-transparent active ETFs challenge this status quo in that they would be tradable on an exchange but would only disclose their positions on a quarterly basis. How will retail investors or broker/dealers know how to value their shares? Will bid-ask spreads widen from this uncertainty?

It is not out of the question that the pricing uncertainty associated with an opaque basket of securities may lead to wider bid-ask spreads. Intraday pricing at intrinsic fair value and the resulting spreads are elements that both regulators and investors should be considering as each affect the implicit cost of owning an ETF. If reasonable solutions can be found, then actively managed ETFs could have a bright future.

Two different paths to non-transparent, actively managed funds

Several U.S. asset managers have filed to market non-transparent, actively managed ETF structures with the Securities and Exchange Commission (SEC). The two frontrunners are Precidian’s ActiveShares and Eaton Vance’s NextShares, and competition between the two has been heated.1

NextShares Exchange Traded Managed Funds (ETMFs)

According to Eaton Vance, its NextShares fund structure is technically not an ETF. It is a new investment vehicle that combines features of a mutual fund and an ETF in a manner that will provide investors with an opportunity to invest in funds that are designed to offer better performance through lower operating expenses and tax efficiency, while remaining fully compatible with active investing. Under the proposal, NextShares would disclose its holdings at the same frequency as mutual funds but trade on an exchange at a discount or a premium to its end-of-day calculated NAV (“NAV-based trading”). Through the NAV-based trading protocol, NextShares will always trade at prices that are directly linked to the funds’ NAVs, negating a reliance on traditional arbitrage with its requirement for Authorized Participants (APs) to hedge intraday exposures to prevent shares from trading with large premiums or discounts to the funds’ NAVs. Much like an ETF, an AP can exchange the basket of securities for shares of the NextShares—keeping the in-kind tax efficiency that ETFs enjoy intact.

We think the true test for NextShares will be education and distribution. Advisors will need to understand the value-add of a NextShares relative to a mutual fund or ETF. Additionally the broker/dealer channels will need to decide whether to commit the capital required to upgrade their systems to support NAV-based trading.

On November 6, 2014, the SEC approved an exemptive order allowing Eaton Vance to offer NextShares and the Nasdaq to list them. Since then, 12 other fund sponsors have received exemptive relief to offer their own NextShares.

ActiveShares Exchange Traded Funds (ETFs)

Correspondingly, Precidian believes the proposed ActiveShares product would also disclose its portfolio on a quarterly basis, and secondary market trading on the exchange would appear identical to that of a traditional ETF. For primary market functions, Precidian would rely on a confidential account structure in which the daily portfolio composition would only be made available to the trusted agents of the APs, and non-AP market makers.

A VIIV (Verified Indicative Intraday Value) would be disseminated to all investors equally on a per-second interval. APs would then place creation and redemption orders with their own confidential accounts. The trusted agent, at the direction of the AP or market maker, buys and sells the underlying basket as a way to hedge the order, while masking the identity of the portfolio. Precidian believes this process, known as “bona fide hedging,” will keep trading of the ETF in line with its NAV at competitive spreads.

This introduces some uncertainty for the AP or market maker, who must now rely on their trusted agent for execution of the underlying basket. The Precidian filing keeps the tax efficiency and intraday trading features intact. Most importantly, it does not disrupt the current distribution infrastructure. Precidian’s biggest challenge will be to convince the SEC, market participants and the general public that these ETFs, given their opacity, will trade in line with their intrinsic NAV. To date, the SEC has not granted approval to the structure.

References: 1 'Eaton Vance Gets Aggressive, Highlights Struggles of Competitor', DailyAlts, July 29, 2015

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