Blue Tractor is one of five firms offering an SEC-approved wrapper for nontransparent actively managed ETFs. Ironically, what makes Blue Tractor’s approach stand out from the other nontransparent structures is the ETF wrapper’s inherent “transparency,” manifested by a daily published creation basket generated by Blue Tractor’s proprietary cloud-hosted algorithm that contains the full list of portfolio holdings, but with a different weighting scheme from the actual portfolio. The delta in weightings between the basket and the portfolio obfuscates the advisor’s alpha strategy and all portfolio trading—thus the wrapper’s “Shielded AlphaSM” name.
To date, Blue Tractor has signed five license agreements, including Nottingham, Tidal ETF Services and Toroso Investments, and anticipates products launched in the first half of 2021. Here, Simon Goulet, the firm’s co-founder, talks about what makes Blue Tractor’s novel approach superior for advisors, market makers and investors.
There are now five SEC-approved active wrapper models, and more could come down the pipeline. Is there a framework advisors can use to sort and organize the differences among all these models?
Absolutely. There’s one key feature in all the wrapper structures that advisors should use to assess the differences—the daily creation basket.
With Precidian’s ActiveShares◊, the creation basket is composed of cash; nobody knows the actual portfolio securities except for the authorized participant representative (AP-R). But as far as everybody else in the market is concerned, it’s a nontransparent basket composed of cash. And the proxy portfolio creation baskets used by NYSE, Fidelity and T. Rowe see securities substituted, or proxied, for actual holdings.
Finally, there’s Blue Tractor’s highly transparent creation basket that holds all the names in the portfolio, but at different weightings between the portfolio and the basket.
So, the framework is simple: Is the ETF creation basket cash, a proxy portfolio or does it contain 100% of the portfolio names like it does with the Blue Tractor wrapper?
The ETF space continues to implement the cloud to better manage operational workflow and data. How has Blue Tractor embraced this technological development?
All the workflow to generate the Shielded AlphaSM creation basket is in Blue Tractor’s cloud-hosted service. So, it’s readily accessible by an advisor or their custodian through a web browser. Our turnkey service is hosted in the secure Microsoft Azure cloud, and an advisor’s portfolio data resides only on U.S.-based servers. I think advisors undertaking due diligence should assess how much of a structure’s operational workflow is in the cloud, and if it’s not very much, then ask why not.
A successful actively managed portfolio is going to accrue capital gains. How does the Blue Tractor ETF wrapper help an advisor to manage or reduce their capital gain footprint?
Tax efficiency is the key benefit of the ETF wrapper versus a traditional mutual fund. Standard dogma explaining ETF tax efficiency informs us that it arises from the ability of an advisor to conduct an in-kind exchange of low-basis, high-gain securities (in return for ETF shares) to an AP through a normal-course redemption transaction, effectively eliminating the capital gain.
However, many of the new nontransparent ETFs are initially going to be buy-and-hold retail products, which means one-way creation flow and limited normal-course redemption activity. So, with limited normal-course redemption activity, how can a nontransparent ETF wrapper really purport to be tax efficient?
Wall Street knows that the actual key to ETF tax efficiency is the ability of an advisor to undertake large, opportunistic in-kind transactions with market makers using negotiated custom baskets, allowing the advisor to deliver the low-basis, high-gain securities on a schedule of their own choosing, rather than waiting for a normal-course redemption to occur (remember that standard redemption activity even for a very liquid ETF more often than not does not occur on a regular basis). Most observers term these opportunistic transactions with a market maker to reduce and defer a fund’s capital gains footprint as a “heartbeat” trade. So, do any of the new wrappers facilitate “heartbeat” trades?
Blue Tractor’s wrapper is uniquely structured to permit “heartbeat” trades when the advisor so chooses. Why? Because of the inherent transparency of the Shielded AlphaSM creation basket, market makers can fully quantify their risks when negotiating an in-kind exchange with the advisor. While the Blue Tractor wrapper does not have true custom basket relief (see below), the ability of the advisor to use the Shielded AlphaSM cloud service tools to adjust the weightings in the basket lets them overweight low-basis, high-gain securities to more efficiently reduce the capital gain footprint.
Transparent actively managed ETFs can use custom baskets, but none of the nontransparent models have custom basket relief. So, is an advisor using the Blue Tractor ETF wrapper resigned to missing out on custom baskets?
Under the recent SEC ETF Rule Change, all transparent ETFs were given the ability to transact using a custom basket, or a creation basket that can be modified by an advisor, or negotiated individually with one or more APs or market makers, so as to confer incremental operational, cost and tax efficiencies to the ETF. However, none of the new active wrappers have custom basket relief.
The good news is that the creation basket for the Shielded AlphaSM wrapper is as close to a custom basket as one can get. Why? Because using the easy-to-use tools in the Blue Tractor cloud service that are unique to Shielded AlphaSM, an advisor can adjust the securities weightings in the daily creation basket to, for example, lower their portfolio trading costs during a creation; enhance capital gains tax efficiency during a redemption; and completely obfuscate when they add a new position in their portfolio or exit from one.
To date, we’re seeing mainly domestic large cap strategies launching under the nontransparent ETF rubric. Is there a reason for that?
Driving this is the fact that the SEC hasn’t really approved an investable universe for the wrappers outside of domestic all-cap equity and other exchange-traded instruments. Effectively, it’s plain vanilla at this juncture; no European or Asian equities, no government or corporate fixed income; and no derivatives and options. Essentially, the SEC has signaled that it wants to see the nontransparent wrappers learn to walk before they’ll let them run. But do note that all of the nontransparent wrappers, excluding ActiveShares◊, are also permitted to invest in foreign equity securities from markets that trade contemporaneously with the U.S., so think Canada, Mexico and Brazil.
But let me finish up with one burgeoning area of investment that I think is particularly well-suited for the Blue Tractor wrapper, and that’s actively managed ESG. That’s because ESG investors tend to be more discerning, since many want to know on a contemporaneous basis exactly what their portfolio holdings are. They don’t want to be surprised end of quarter to find out that what they thought was a socially conscious portfolio began to chase alpha in a different direction that now makes them feel uncomfortable. They are going to want ETFs in a wrapper that provides them with the most transparency. They want to see the securities their ESG fund holds; and of course, that’s only available with the Blue Tractor wrapper.
Currently there are no ETFs approved by the United States Securities and Exchange Commission (SEC) using the Shielded AlphaSM ETF wrapper and this document is not meant to promote any ETFs described in registration statements under review by the SEC.