Fidelity Hedges Its Active ETF Bet

Without much fanfare, Fidelity throws its hat in nontransparent active ETF ring.

In all the hubbub about PIMCO over the last few days, Fidelity may have actually made one of the more interesting ETF moves in the traditional active management space. Last week, the firm filed paperwork with the SEC to run nontransparent actively managed ETFs.

What’s interesting—at least to an ETF nerd like me—is that Fidelity didn’t choose one of the two big competing structures; it took a third path.

The Blind Trust

Most of the industry has thrown its weight behind a Precidian Investments-based blind trust model for nontransparent active ETFs. That’s what where BlackRock, SSgA and American Funds (just to name a few) are headed.

In the blind trust model, authorized participants (APs) don’t actually deal with the fund company at all; they deal with the trust, and that trust handles generating or disposing of the creation/redemption basket with the fund itself.

It’s an elegant structure that preserves all of the tax and transaction-cost advantages of traditional ETFs. The trade-off is that the Street doesn’t know exactly what’s in the portfolio, which makes it a little more difficult to hedge creations and redemptions.

Even if enormously successful, my prediction is that the Precidian-based products will have slightly wider spreads in the open market to account for this information slippage.

The Hybrid

The competing structure, proffered by mutual fund company Eaton Vance, abandons the traditional market altogether; in fact, Eaton Vance doesn’t even call them ETFs, it calls them “exchange traded managed funds.”

ETMFs would not disclose holdings and would trade in a new way—a premium or discount to NAV.

APs would have some sense of what NAV will be because Eaton Vance (or anyone else using the ETMF structure) will put forth a proxy basket that is supposedly good enough.

I’ve been less than kind to the idea that the Street is going to learn a whole new way to trade just to accommodate these things. But hey, it’s a free market, and the best structure will win.

FIDO’s Third Way

Fidelity is doing something different, and frankly, it seems a bit boring. Fidelity already runs ETFs, so it didn’t need new exemptive relief. It already has regular old transparent active ETFs in registration as well. And Fidelity’s approach to the nontransparent active idea is as simple as it comes.

In the filing, it proposes just running a regular old ETF, not telling anyone what it holds more than once a month, and publishing a “tracking” basket every day. That tracking basket will in fact be live—it will have actual securities listed that Fidelity will take in-kind for new creations and put to the APs for redemptions. It will generally be something like the portfolio, but it won’t be perfect, and it can frankly be anything they want. It could even be cash.

It’s blisteringly simple, so in that sense, I applaud it. But it is also somewhat “head in the sand” in terms of preserving all of the benefits of ETFs.

First off, it makes the APs’ jobs harder, and APs will respond by just opening up spreads. Compared with the blind trust structure (where I expect cash to be the coin of the realm), you’re making the AP do all the work with none of the tracking certainty. That just means bigger premiums and discounts to true fair value over time.

Second, managing the tax lots will be much trickier. If the ETF wants to unload something, it will either have to sell it on its own, or slip it into a separate redemption basket.

Having two baskets—one for creations and one for redemptions—isn’t at all unheard of, but if you’re trying to be sneaky about your trading, it defeats the whole purpose. It’s like putting up a giant sign that says: “By the way, we’re selling this!”

Fido could of course make the tracking basket as close to, or as different from the “real” portfolio as it wants, on any given day. It could effectively put the whole portfolio in it, making it actually transparent.

Will it work? It’s a huge unknown.

Structurally, Fidelity’s idea is dirt simple, and so I don’t see any impediments to it working structurally, or getting approval. But will it in fact be a better mousetrap, preserving everything that’s awesome about ETFs but letting the “Magicians of Massachusetts” cook up their potions in private?

The market will decide, but I think the mice are pretty safe.

You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.