The sponsor behind SPY joins BlackRock in efforts to make nontransparent active funds a reality.
State Street Global Advisors, the fund sponsor behind SPY, the first and biggest U.S. ETF, filed regulatory paperwork to gain permission to market nontransparent, actively managed ETFs that is essentially identical to paperwork iShares’ parent BlackRock Inc. filed in the summer of 2011 and the one Precidian Investments submitted early this year.
Unlike already-live transparent active ETFs—like Bill Gross’ nearly $5 billion Pimco Total Return ETF (NYSEArca: BOND)—SSgA’s “exemptive relief” petition to the SEC is asking to market ETFs that have periodic portfolio disclosures, such as those the SEC requires for mutual funds. In fact, the SSgA petition is based on the very same patent as the BlackRock and Precidian proposals.
At the center of State Street’s proposal is a blind trust that works 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 that the new plan, if approved by the SEC, would include disclosure requirements similar to those in place for mutual funds.
State Street noted in the paperwork that it has three separate nontransparent, active funds in mind in the event the Securities and Exchange Commission does approve the petition. Those funds are:
- SPDR SSgA Equity ETF
- SPDR SSgA Emerging Markets ETF
- SPDR SSgA Aggregate Bond ETF
State Street’s plans, and those of BlackRock and Precidian, are part of a broader trend in the world of ETFs to offer up a mechanism that would allow fund companies to seek outperformance with actively managed strategies that enable mutual fund managers to keep portfolio holdings under wraps long enough to profit from ostensibly superior ideas.
Other such plans similar in spirit, though different in structure to what SSgA is proposing, are those for the nontransparent ETFs the mutual fund company Eaton Vance has in the works. Eaton Vance proposes bringing to market exchange-traded managed funds, or ETMFs, that make use of what it calls “NAV-based trading.”
All these nontransparent active ETFs stand in sharp contrast to the vast majority of existing ETFs, which are indexed vehicles. Indeed, more than 99 percent of the $1.5 trillion invested today in U.S.-listed ETFs is in indexed vehicles, with the remainder in funds like Bill Gross’ BOND, which is active but must disclose portfolio holdings daily.
BOND is the most successful active ETF to date, but some industry sources believe that if State Street’s nontransparent active plans are approved, 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.
Under the plans proposed by State Street, BlackRock and Precidian, APs for such nontransparent active ETFs 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, 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.
Regarding creations in the proposed structure, the State Street filing—with the exact same language as the BlackRock 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 sub adviser 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 aspect remains the same, 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.