Natixis: Quest For Nontransparent Active ETFs

If approved, the structure could offer investors attractive benefits.

Reviewed by: Natixis Investment Managers
Edited by: Natixis Investment Managers

Terry RitchieNick Elward is a senior vice president and head of institutional product and ETFs at Natixis Investment Managers. He is one of the people spearheading the firm’s effort to launch actively managed nontransparent ETFs, a general concept the SEC has been wary of but is now coming to accept. Here, Elward discusses Natixis’ reasons for working to bring the vehicles to market and the process it must navigate to gain the SEC’s acceptance and make the products a reality. Why is Natixis taking a leadership position in exploring the active nontransparent ETF structure?
Natixis has a long history of being very supportive of and adept at active portfolio management. We launched our ETF business almost three years ago, and currently offer active transparent ETFs only. We disclose our holdings for these ETFs, the Natixis Seeyond International Minimum Volatility ETF (MVIN) and the Natixis Loomis Sayles Short Duration Income ETF (LSST), daily.

We realize that in order to offer investors more options for active management, it would be great if we could bring more of our portfolio managers into the active ETF space. In order to have them do that—because those managers use fundamental research as the approach and are concerned about people potentially front-running their trades and free-riding their product—we would have to have an active nontransparent ETF structure approved. We decided to partner with the New York Stock Exchange (NYSE) on an active nontransparent ETF filling. Has front-running trades been a problem with existing active ETFs?
Elward: We have not had any issues with front-running of our two ETFs. When we're trading for those ETFs, we can finish building a position in a single day. By the time we disclose our holdings the next day, we have already built our position in that new security rather than doing so over two or three days, when someone could try to benefit from that situation.

But for ETFs that are very large or that use fundamental research as their input, that could be an issue. An active nontransparent ETF vehicle could address this issue. Would you talk about what the current regulatory environment is like for active nontransparent ETFs?
Elward: The SEC has been very open to talking with potential providers of active nontransparent ETFs. They've already approved one approach, and some asset managers are beginning to go through the steps of launching an active nontransparent ETF under that model. But other firms are seeking SEC relief for different methodologies. Natixis and the NYSE are jointly seeking SEC relief for a unique proprietary NYSE methodology that, if approved, would enable Natixis to launch a nontransparent ETF. What are the benefits you see investors deriving from active nontransparent ETFs?
Elward: There are some purely ETF-related benefits. Those include, first and foremost, tax efficiency. ETFs, based on the way that they're constructed, tend to be more tax efficient than other vehicle types, such as mutual funds. So those investors that own these active ETFs may benefit from that perspective, on the tax efficiency side. That's the No. 1 benefit that I see accruing to investors.

A second benefit is likely to be cost savings. Transfer agency fees are typically much lower for an ETF than a mutual fund of similar size, because there are fewer accounts that directly transact with the ETF, as opposed to the mutual fund.

So those are two benefits that nontransparent active ETF investors could enjoy, but others include less cash drag and intraday trading. And we believe the other benefit of active nontransparent ETFs is just giving those investors the opportunity to outperform an index, whereas with passive funds, they basically sign up to underperform the index from the start, because obviously you can't replicate an index when you include expense ratios and trading costs. The benefit here is just pure active asset management and the opportunity to outperform the index. Is this going to be just a more efficient vehicle for a traditional mutual fund strategy?
Yes, I'd say for the most part it would be. It's a way to get the investment capability into the hands of the investor in a wrapper that can prove to be more cost effective and more tax efficient for the investor.

Say you like a certain active manager, and you previously owned a mutual fund they managed. If you could now own an ETF they managed, wouldn't you want to do that? I think a lot of people would say yes. What type of investment strategy do you think will be among that initial wave of launches once this structure gets approved?
Elward: Our approach is to focus on U.S. equity strategies—large to midcap companies that trade within U.S. time zones. That's what I think you'll see initially. And after, we would work with the SEC to see if we can get approval for, as an example, non-U.S. securities and also fixed income securities.

The U.S. equity space is the simplest of the different kinds of potential product launches because, again, they trade very simply during U.S. market hours. If you look at international stocks that trade at different times, it creates some additional complexity, where it's a little bit harder to keep the spread tightness where you want it for an ETF. It's easier to do that for U.S. equities as opposed to international equities, just as one example. What kind of reception are you expecting from the marketplace?
Elward:  I think it will be slow in general for the large broker-dealer firms to adopt active nontransparent ETFs. They will probably proceed with caution and run the different ETFs that launch through their research processes. I'm sure there will be early adopters, the ones that want to get ahead of the curve, and they'll be looking at these products and will want to put them into their investors' portfolios sooner rather than later. It may be the RIA market and maybe some of the independent firms that will be early and fast on this.

In general, I think it could take a year-plus for us to see reasonably good sales momentum across the board in active nontransparent ETFs. And partly that would be due to the fact that certain buyers will—again, for good reason—want to see how the active nontransparent ETFs trade to ensure that spreads are reasonable. What has Natixis done to reach out to the market makers who have never before traded portfolios they can’t readily see?
Elward: We definitely talk with the key market makers all of the time. The fact that we're working with the NYSE on this initiative is really helpful, since all the market makers have good relationships with the NYSE, and some trade on the floor. We've been able to test all the thinking related to our active nontransparent ETF model with market makers to ensure that they believe they can make good markets on the active nontransparent ETF approach we are proposing.

One of the things that makes us different from others is that we intend to use a proxy portfolio approach for active nontransparent ETFs. That means, instead of us showing all of our holdings every morning—as we do for active transparent ETFs—we create a proxy portfolio. We make the holdings in that proxy portfolio available every morning to the market makers and the public. The proxy portfolio will be optimized to be highly correlated to the actual basket of stocks that are in our ETF. The market makers can use this proxy portfolio, along with other select daily data that we would publish, to be able to confidently set the spread on active nontransparent ETFs and keep premiums and discounts to the NAV in check. What determines the proxy portfolio?
Elward: We would disguise those holdings that we've been active in recently and we would simply find stocks that have high performance correlation to those that we don't want to show and include those in our proxy portfolio.

As an example, if we had 50 stocks in our actual portfolio and our management team is trading on, say, three of those stocks, they would not want to let the market know what they are doing. So those are the three stocks whose exposure may be proxied; whereas, we may decide to disclose those other 47 holdings because the portfolio will be more tax efficient if we include the actual holdings in the proxy portfolio basket, which is the same as our creation/redemption basket.

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