Active ETF Proposals Only Solve Half The Problem

August 16, 2016

For years, really smart people have been trying to figure out how to shoehorn active management strategies into the ETF wrapper. Fidelity is the latest to try, and as explained by my good friend Dave Nadig, its new proposed design is clever.

The problem firms like Fidelity are trying to solve is that current Securities and Exchange Commission rules require actively managed ETFs to disclose their full portfolios on a daily basis.

Particularly in the equity space, active managers do not want to do that, because they fear that hedge funds and prop traders will use that information to front-run their trades.

The Fidelity proposal takes the clever approach of creating what amounts to a closed-end fund (CEF) and ETF hybrid. New products would be structured as closed-end funds, which allow for more limited disclosure, but would have weekly creation/redemption activity that could help solve the big problem with CEFs—their tendency to trade at large premiums and discounts.

Pricing Nut Tough To Crack

Like most proposals for quasi-transparent and nontransparent active ETFs, I’m pretty sure the Fidelity approach will work. For all of the structures I’ve dug into, it strikes me that the benefits that accrue to using an ETF structure instead of a mutual fund structure far outweigh the risks created by any aspect of nontransparency.

For those who don’t know, the big concern with nontransparent ETFs is that the market may not know how to price them perfectly; as a result, officials worry they could trade at unknowable premiums and discounts to their net asset values. That’s probably true to some extent, and despite clever efforts like Fidelity’s to mitigate the problem, I’d be surprised if nontransparent ETFs didn’t trade a few pennies wider than transparent funds.

However, the benefits that offset that are significant: lower costs, greater tax efficiency, more trading flexibility and a fairer allocation of entry and exit costs compared to traditional mutual funds.

To me, it’s not even close. If mutual funds didn’t exist today and someone were trying to launch one, they’d be laughed out of the room. Imagine the SEC considering a structure that allowed shareholders who continue to hold a fund to pay the trading costs for people who are selling out of a fund. It’s absurd on the face of it. Eventually, I think the SEC will see that the balance of good favors nontransparent ETFs.


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