Can Nontransparent ETFs Save Active Mgmt?

June 13, 2019

  1. Complexity. The daily transparency of traditional ETFs helps authorized participants (APs) keep the price of an ETF in line with the value of its underlying holdings. Without that daily transparency, ActiveShares will use an AP representative or a “trusted agent,” who sits between APs and the ETF sponsor. The trusted agents will be the only players outside of the fund managers and custodians to know an ActiveShares ETF’s holdings and weightings. The trusted agents will perform creations and redemptions on behalf of APs using confidential accounts. There is some complexity involved here. Whenever a layer of complexity is added, the room for error grows. Concerns have been voiced over bid/ask spreads (think transaction cost: the difference in price between what an investor can buy and sell shares at) given that APs won’t know the exact underlying holdings. If bid/ask spreads are higher for ActiveShares, that could offset some or all of the fee and tax savings. Concerns have also been raised regarding insider trading (which the SEC has rebuffed). AP representatives will be under contractual obligation to not disclose holdings. Regardless, investor education will be needed to explain how these products work. The fund industry doesn’t necessarily have a reputation as a high quality educator. Morningstar’s Ben Johnson wonders who the additional complexity benefits, noting: “This solves the problem for asset managers, but it does little for the end clients.”

Why Transparency Wins

I still believe the best route for fund companies is to simply launch their flagship equity strategies using the transparent ETF wrapper. I previously laid out the case why. The bottom line is transparency equals trust. Since the global financial crisis, the investment world has been moving toward greater transparency, not less. Knowing exactly what your investments hold provides a level of trust.

From a portfolio management perspective, transparency helps avoid overlap of holdings (owning the same securities in multiple funds) and allows the monitoring of style drift (a manager drifting from its stated investment objective).

As it relates to manager fears of divulging their “secret sauce” and trade front-running, I have spoken with numerous active managers using the transparent ETF wrapper. I consistently hear the same message: These fears are overblown. The fact is there are currently active managers generating outperformance using the traditional ETF structure.

Also, let’s assume a manager’s strategy can be reverse engineered. Who is going to copy it? Is it a fund company wanting to launch the exact same strategy? Why would they do that? Even if they do, can they stick with the strategy? How similar will it really be? This is easier said than done. Is an individual investor going to steal the secret sauce? If so, does it matter?

ETFs The Future Of Active

So what actually happens? We know ETFs are where the future growth lies in the asset management space.

“We have launched one mutual fund in the last 18 months, but we’ve launched many more ETFs—and we’re a traditional mutual fund company. And I think that is a common experience,” said Joe Sullivan, CEO of Legg Mason.

All signs point to active ETFs as the likely candidate for higher rates of future growth. Cerulli found 37% of fund managers are planning to develop active ETFs and 22% nontransparent ETFs, compared with 18% for passive and 11% for strategic beta.


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Source: Cerulli

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