BlackRock Plans Nontransparent Active ETFs

September 01, 2011

BlackRock drops a bomb with plans to earn the right to market nontransparent active ETFs.


BlackRock, the parent of the world’s largest ETF firm, iShares, filed paperwork with the Securities and Exchange Commission to gain permission to market nontransparent, actively managed ETFs, a major development considering BlackRock’s size and the fact that active ETFs have yet to take off.

Unlike transparent active ETFs already on the market from the likes of AdvisorShares and Pimco, BlackRock’s “exemptive relief” petition to the SEC is pushing for periodic portfolio disclosures such as those the commission required for mutual funds. It’s also quite unlike plans for nontransparent ETFs the mutual fund company Eaton Vance has in the works.

At the center of BlackRock’s plans is a blind trust working on behalf of the authorized participant (AP) that would keep disclosure of portfolio holdings under wraps until regulators require it. Existing mutual funds must disclose holdings every three months with a lag, and it appears BlackRock’s plan, if approved by the SEC, would include disclosure requirements similar to those in place for mutual funds.

“While the funds are nontransparent ETFs, Applicants do not believe that the Funds raise any significant new regulatory issues or that the lack of disclosure regarding a Fund’s portfolio holdings on daily basis will in any way make the fund more susceptible to manipulation for the benefit of one group over another, the filing said.

Day to day, though, APs for the products would effectively be doing creations and redemptions for cash and hedging the funds based on the fact that they could redeem shares for the exact cash value of the funds’ net asset value (NAV). Creations and redemptions would happen in kind in the blind trust, allowing the fund to enjoy some of the tax efficiencies that transparent ETFs currently enjoy.

Crucially, the blind trust would be able to do what APs at the center of any index-based ETF are able to do as well, such as eliminating higher-cost securities to get rid of imbedded capital gains at the fund level. Such cherry-picking of securities is a key reason ETFs are considered to be more tax efficient than mutual funds.

BlackRock’s concept goes to the heart of an ongoing pursuit in the money management industry to provide strategies that aim to beat market benchmarks. A big part of that pursuit is a belief among managers that keeping portfolios secret gives them an edge over others in the market. Without that, they say, anybody can quickly steal their “secret sauce” and undermine their edge.



Officials at San Francisco-based iShares declined to comment on the filing.

“Applicants believe that the availability of real-time pricing information will allow market participants to hedge trading exposures in shares effectively and permit the efficient trading of shares in the marketplace without the need for daily disclosure of the funds’ portfolio holdings,” the filing said.

“Further, Applicants believe that nontransparency avoids the risks of ‘front running’ and ‘free riding’ to which actively-managed funds that disclose their holdings are subject.”

BlackRock specifically mentioned a number of domestic equity ETFs it plans to roll out should the SEC approve its application, and also made passing mention of fund-of-funds strategies that could be rolled under the same exemptive relief.

It wasn’t immediately clear if the new funds would be marketed under the BlackRock or iShares name, though it's quite likely they will be iShares funds since iShares is the ETF arm of BlackRock's vast money-management business.

San Francisco-based iShares manages more than $430 billion in ETF assets, all of them indexed strategies, save for one, the iShares Diversified Alternatives Trust (NYSEArca: ALT). ALT, an active strategy with fully transparent holdings that are disclosed daily, was down 1.2 percent year-to-date through Aug. 26.

For its part, New York-based BlackRock is the world’s largest asset manager, with a total of $3.66 trillion under management as of June 30, according to information posted on the company’s website.

Exemptive relief grants fund firms exemptions from parts of the Investment Company Act of 1940, giving them the right to market ETFs. It typically takes six to nine months from the time an exemptive relief filing is made for the first funds under the exemptions to reach market.

iShares did obtain exemptive relief to market actively managed funds early this year, but it only covered ETFs that are transparent and disclose portfolio holdings daily.

Transparent Active Funds

BlackRock’s plans amount to a radical departure from actively managed strategies to date.

As it stands, the SEC requires daily disclosure of portfolio holdings of any ETF, whether it’s actively or passively managed.

Companies like AdvisorShares, Pimco and WisdomTree have had some success gathering assets in such actively managed strategies that disclose holdings daily.

For example, the AdvisorShares Cambria Global Tactical ETF (NYSEArca: GTAA) now has about $174 million in assets, and the Pimco Enhanced Short Maturity Strategy (NYSEArca: MINT), a money-market fund proxy, now has more than $1.3 billion in assets.

Additionally, the WisdomTree Tree Emerging Markets Local Debt Fund (NYSEArca: ELD) has gathered more than $1.4 billion.

Apart from these success stories, most actively managed funds that have gained any traction are fixed-income or currency strategies.

As things stand, just over $6 billion in assets are in active ETFs, or around 0.5 percent of the $1.064 trillion in total U.S.-listed ETF assets at the end of August, according to data compiled by IndexUniverse.



A Nontransparent ETF Future?

Boston-based Eaton Vance has said it is planning to market nontransparent ETFs using patents it obtained when it acquired Managed ETFs, a company owned by longtime ETF industry consultant Gary Gastineau.

The Eaton Vance plan centers on the use of trading based on a fund’s end-of-day NAV.

NAV-based trading allows managers of nontransparent funds to trade securities throughout the day at prices determined at or relative to net asset values calculated on that day.

It’s an idea that makes some advisors wonder whether the trading efficiency of ETFs might be compromised if intraday purchases and sales wouldn’t be definitively priced until the end of the session, and Eaton Vance has declined to comment on its plans, saying they are still in development.

The firm obtained exemptive relief from the SEC to market active funds, though the order didn’t stipulate nontransparent funds.

A Different Ball Of Wax

The disclosure requirements described in the BlackRock filing seem to be much closer to currently prevalent disclosure requirements for mutual funds.

That’s significant because a number of industry sources say that the many mutual fund companies that have made tentative steps to begin offering exchange-traded funds might leap head first into the ETF business if they could keep their portfolio disclosures to a minimum, as they do now.

Mutual fund companies are also said to be loath to transition assets from existing funds into cheaper funds. Moreover, much of the mutual fund industry’s success is predicated on a well-oiled distribution machine. That means that assets segueing into ETFs, where distribution infrastructure is relatively minimal, would mean the mutual fund industry would lose contact with many of its end investors.

Regarding creations in the proposed BlackRock structure, the filing said:

“Since Creation Units will be created solely by the deposit of cash and will typically be redeemed by distributing securities of the fund’s portfolio to a blind trust that will liquidate the portfolio securities in accordance with instructions from the authorized participant redeeming shares, neither the adviser nor the fund subadviser will be able to cause an authorized participant to engage in transactions in which the funds could not engage directly or to otherwise use the in-kind process to circumvent applicable restrictions under the Act.”

Also, when ETF shares are liquidated, the AP would receive cash, again, never knowing what made up the ETF shares that the blind trust redeems.

Crucially, the blind trust becomes a part of the creation and redemption mechanism that is at the center of how an ETF functions. Because that doesn’t change, that means tax inefficiencies and cash drag that are the Achilles’ heels of many mutual funds are likely to be neutralized under the proposed structure.

When faced with redemptions, the fund would have two choices of response: It could raise cash at the fund level if it has a loss it wants to lock in for tax reasons, or it could hand out shares in-kind to the blind trust that would then liquidate shares on behalf of the AP.

Planned Funds

Among the equity ETFs BlackRock said in the filing it is contemplating bringing to market under its exemptive relief filing are:


Large Cap Fund



Large Cap Value Fund



Large Cap Growth Fund



Large/Mid Cap Fund



Large/Mid Cap Value Fund



Large/Mid Cap Growth Fund



Large Cap Long-Short Fund



Large Cap Value Long-Short Fund



Large Cap Growth Long-Short Fund



Large/Mid Cap Long-Short Fund


Large/Mid Cap Value Long-Short Fund


Each of the funds will invest—or, for long-short funds, take short positions—primarily in the 1,200 largest U.S. stocks by market capitalization as determined annually by the Frank Russell Company, the filing said.


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