[Correction: An earlier version of this piece stated that the NYSE/Natixis proposal used a distinct creation basket for creation/redemption. As of its most recent filing, however, their structure will use its proxy portfolio for creation/redemption. The text has been revised to reflect the correction.]
On Nov. 14, the Securities And Exchange Commission (SEC) granted notice of intention to approve four proposed ETF structures that would forgo daily publication of their portfolio holdings, a feature their issuers hope will entice more active managers to the ETF market.
Formal approval of these non- or semitransparent active ETF structures is expected to occur on or around Dec. 10, barring any public request for further hearings.
Transparency: Double-Edged Sword?
These structures are a response to ETFs' daily portfolio transparency—long an industry tradition that the SEC’s new ETF Rule has codified into law.
According to the ETF Rule, most issuers are now required to publish daily which securities they hold and in what amounts, so that investors always know what they own. (Read: "SEC Passes Landmark 'ETF Rule.'")
However, some active managers worry that transparency can be a double-edged sword. Knowing what you own also means that everybody else knows what you own, opening actively managed funds up to front-running or free-riding.
As a result, many well-known active managers have avoided launching ETFs; those that have launched funds tend to concentrate on passive, index-based strategies.
For the active ETFs that have come to market with daily disclosures, assets have been slow to build. Currently, the 144 alpha-seeking equity ETFs total just $14 billion in assets invested—or 0.3% of total assets in U.S.-listed ETFs overall. Although active management is more popular in fixed income funds, the 112 active bond ETFs still account for just 1.8% of total ETF assets in that space.
A New Active ETF Mousetrap
Some have theorized that if there were an ETF that preserved all the tax benefits, reduced costs and intraday trading benefits of the regular structure, but that also concealed its portfolio against prying eyes, the active managers remaining on the sidelines might finally be enticed to launch their own ETFs.
In 2016, Eaton Vance Corp. launched a series of "exchange-traded managed funds," or ETMFs. Although these funds trade intraday, they only disclose portfolio holdings quarterly, with a 60-day lag; meaning, ETMFs exist in some nebulous space between ETF and mutual fund, falling into neither camp cleanly.
Although widely reported on at their time of launch, ETMFs have since struggled to take off. As of Nov. 24, there were only three remaining NextShares products, down from 11, with $20.3 million invested.
Then in May of this year, the SEC granted approval to the first true nontransparent fund ETF structure, Precidian's ActiveShares ETFs. Though no ActiveShares funds yet have launched, interest in them has been brisk: Precidian has already signed over a dozen licensees, including several firms that already have their own ETFs, such as Goldman Sachs, J.P. Morgan, IndexIQ and Nuveen.
With the SEC's latest nod of approval, however, what was once a one-horse race now has widened into a field of five, with each proposal offering a unique twist on the concept of concealed alpha. We have summed up some of the key differences in the table below:
|Important Distinguishing Features Of Semitransparent Active ETF Structures|
|Precidian's ActiveShares ETFs||Blue Tractor Group's Shielded Alpha ETFs||NYSE's Periodically Disclosed Active ETFs||Fidelity's Actively Managed ETFs||T. Rowe Price's Active ETFs|
|How does it conceal actual holdings?||Uses an AP representative||Uses algorithm to randomly generate weights for 0-10% of holdings||Uses proxy portfolio of actual holdings in differing weights, as well as additional names||Uses proxy portfolio of actual holdings (in differing weights), representative ETFs and cash||Uses proxy portfolio, which would determine at least 80% of the real portfolio's holdings|
|How often does it provide intraday pricing information?||Provides iNAV of the real fund portfolio every second||N/A||N/A||Provides iNAV of the tracking basket every 15 seconds||Provides iNAV of the real portfolio every 15 seconds|
|What is used in creation/redemption?||The real fund portfolio||The Dynamic SSR portfolio||The proxy portfolio||The tracking basket||The hedging basket|
|How often are the real holdings disclosed to the public?||Once per quarter||Once per quarter||Once per quarter||Every 30 days||Once per quarter, with 15-day lag|
Precidian Introduces An AP Go-Between
Without the benefit of daily portfolio transparency, making the machinery of ETFs work becomes more difficult. Authorized participants (APs) have a harder time accurately calculating intraday valuations, which in turn increases the complexity of creating and redeeming ETF shares. Each of the five semitransparent active ETF structures grapples with these challenges in its own way.
For example, Precidian's ActiveShares ETF uses a go-between known as the AP representative ("APR") to facilitate creation/redemption.
Besides the portfolio manager, only the APR knows what's inside the ETF's portfolio at any given time; meanwhile, investors and APs alike are left in the dark. (However, ActiveShares funds still publish their holdings once a quarter, similar to mutual funds.)
When an AP wants to create or redeem ETF shares then, they deliver cash via a confidential account to their personal APR, who then uses it to buy/sell the securities needed for creations and redemption. (Read: "Nontransparent Active ETFs Explained.")
"Because you're actually utilizing the underlying securities [in the portfolio] to create and redeem, there's no tail risk between a substitute portfolio and the NAV [of the actual holdings] at the end of the trading day," said Dan McCabe, Precidian's chief executive officer. "Our creation/redemption process will be the most similar to what's available today, except the manager doesn't need to disclose [holdings]."
Verified Intraday Indicative Value
ActiveShares ETFs also publish a "verified intraday indicative value" ("VIIV"), or a calculation of the hidden portfolio's net asset value that updates on one-second intervals throughout the trading day.
As a result, ActiveShares ETFs arguably provide more pricing transparency than the traditional intraday net asset value (iNAV), which updates every 15 seconds. Indeed, iNAV has largely become obsolete for vanilla ETFs, given that daily portfolio transparency allows APs to calculate their own up-to-the-second valuation. (Read: "ETF Eulogy For iNAV.")
"In our mind, it's critical that we share accurate pricing information with the investing public on a real-time basis," said McCabe. "Otherwise, you have no benchmark to judge yourself by."
Blue Tractor: ‘Nearly Transparent’
Then there are the four semitransparent active ETF structures that earned the SEC's nod of approval earlier this month. Each camouflage some or all of the securities in the fund's actual portfolio.
Arguably the least camouflaged is the Shielded Alpha ETF from Blue Tractor Group. Although technically a nontransparent ETF, the firm itself prefers the term "nearly transparent," says co-founder Simon Goulet.
"We believe in transparency, because transparency is what made ETFs successful to date," he said. "It's not just important to investors and brokers, but to the market makers who need to understand their risks."
A Shielded Alpha ETF publishes a daily basket of portfolio holdings (called its "Dynamic Stock Specific Risk Portfolio," or Dynamic SSR Portfolio) that includes 100% of the security names in the real portfolio, in at least 90% of their actual weightings.
The remaining 0-10% is decided via an algorithm that randomly generates weightings, while simultaneously reducing tracking error between the Dynamic SSR Portfolio and the actual fund holdings.
For example, if the fund holds a 2% weight in IBM, then one day it might appear in the Dynamic SSR Portfolio as 1.98%, then 2.01% the next, then 1.99% the next. (Guardrails are implemented to ensure the adjusted security weightings don't deviate too far their actuals.)
"You never know if the movements are the result of trading from the portfolio manager or artifacts of the algorithm," said Goulet.
Don't Call It A Proxy Portfolio
Although often lumped in with proxy portfolio solutions (see below), Blue Tractor's Dynamic SSR Portfolio doesn't use substitute stocks. All that's changed are individual security weights.
Also, unlike the proxy portfolio models, "the market will never know the actual overlap between the two portfolios," added Goulet. The aggregate size of the algorithmically generated portion of the portfolio changes day to day and is never disclosed.
However, just like mutual funds, the actual fund holdings will be published quarterly.
One additional feature: Blue Tractor gives portfolio managers the ability to directly tweak their alternate portfolios via a cloud-based platform. (In comparison, the three proxy portfolio solutions leave this up to their algorithms.)
NYSE: ‘Periodically Disclosed Active ETFs’
A true proxy portfolio solution comes from the NYSE, who developed it in partnership with Natixis, its first licensee.
NYSE's model disguises a manager's trading activity through a proxy portfolio, which has different security names and weights than the fund's actual holdings, but which performs substantially the same. Indeed, the proxy portfolio is structured such that its intraday NAV will match that of the actual fund (at least as of the time when the proxy is first constructed).
This proxy portfolio—which consists of the fund's actual holdings, but on a 5- to 15-day lag, as well as additional names that do not appear in the real fund at all—will be published every day, and can be used for intraday pricing and hedging.
Substitute stocks are selected via a sector-agnostic factor analysis model, which seeks out securities that are expected to have similar return characteristics as the actual holdings they replace.
The rest of the real holdings can be fully disclosed, says Nick Elward, senior vice president and head of institutional product and ETFs for Natixis.
"That's how we get a low tracking error between our model and the actual portfolio," he said. "It meets in the middle between transparency and nontransparency."
As of the most recent filings, the NYSE model uses its proxy portfolio for creation/redemption. The real fund's holdings will be disclosed quarterly, just like a mutual fund. In addition, the NYSE will publish daily historical tracking error between the NAVs of the proxy and real portfolios.
Natixis already has two active, quant-style ETFs on the market, but Elward says that until now, fear of front-running or of someone copying their fundamental trading strategies has prevented them from releasing more.
"We see this [structure] as additional, vehicle-level alpha," he said.
Fidelity's Actively Managed ETF
In the Fidelity model, a "tracking basket" (i.e., a proxy portfolio) is constructed via mathematical optimization, so as to select substitute securities that minimize trading costs and return deviation from the actual holdings.
This tracking basket will include the fund's actual holdings (though in differing weights) and representative ETFs (which won't appear in the real portfolio at all), as well as cash and cash equivalents.
Its holdings will be published daily and can be used for creation/redemption and intraday pricing. In addition, Fidelity will publish the tracking basket's iNAV every 15 seconds.
Most Frequent Portfolio Disclosure
What's more, Fidelity will publish the constituents of the real portfolio on a 30-day lag, including all the names in their accurate weights.
As a result, Fidelity's model offers the most frequent and thorough disclosure of what's really inside its fund portfolio of all the new structures, putting it on par with Vanguard's existing line of semitransparent ETFs.
Additionally, Fidelity will also publish daily the percentage overlap between its tracking basket and the real portfolio, as well as the return deviation between the iNAVs of the two portfolios.
"We've tried to make a product that feels like it fits into the ETF ecosystem as it exists today," said Greg Friedman, Fidelity's head of ETF management and strategy.
Although the structure was designed with Fidelity in-house strategies in mind, the firm is keeping open the possibility of licensing, he adds.
T. Rowe Price Embraces ETFs
Active management behemoth T. Rowe Price has also filed for a proxy portfolio structure, one designed specifically for the firm's proprietary active strategies, says Tim Coyne, head of ETFs for the firm.
The requirement for daily transparency has so far kept T. Rowe Price out of the ETF market, he said, adding "We don't view this [model] as 'nontransparent.’ We view it as equivalently transparent to [what we offer] our existing shareholders."
Like the Fidelity and NYSE models, T. Rowe Price would publish daily a proxy portfolio (or "hedging basket") whose NAV closely matches that of the actual fund's holdings. (Despite the name, the hedging basket can and will also be used for creation/redemption activity.)
The firm has left itself wide discretion in how to construct this portfolio. Constituents could be securities from a broad-based index, like the S&P 500, or pulled from recent holdings of the underlying fund.
But the filing states that each ETF would invest at least 80% of its assets according to the names and weights found in the proxy portfolio, rather than the other way around. (Actual fund holdings will be published quarterly, on a 15-day lag.)
T. Rowe Price will publish an iNAV for the real fund portfolio, updated every 15 seconds (the hedging basket's iNAV will be left up to market makers and APs, however).
"We think it's important that market makers get an accurate pricing signal for these funds," said Coyne. "As such, we consider ours a 'hybrid' pricing model."
A Relatively Static Proxy
In addition, T. Rowe Price will publish the daily return deviation between the fund and its hedging basket, as well as the tracking error and percentage overlap between the two portfolios.
Intriguingly, T. Rowe Price expects that its proxy portfolio will remain fairly static, stating in its filing that although the proxy portfolio can change at any time, the firm "does not expect to make such changes more frequently than quarterly" (i.e., in advance of its quarterly disclosure of the real fund holdings).
Furthermore, the filing states that "the number and size of differences between the actual portfolio and the Proxy Portfolio will generally be insignificant," making it unclear just how much of its portfolio T. Rowe Price's structure will ultimately conceal.
Unlike the other issuers, T. Rowe Price is uninterested in licensing its model to third parties, says Coyne. In fact, the firm views its approach as a secret sauce to give T. Rowe funds a leg up in the marketplace.
"We see this as a way to expand our client base," said Coyne.
Everything Old Is New Again
Taking a giant step back, it's worth noting that ETFs that do not disclose their portfolios daily are nothing new. For example, Vanguard ETFs, which exist as separate share classes of the firm's mutual funds, only disclose their holdings on a monthly basis, with a 15-day lag. (Notably, Vanguard's ETFs are exempted from the new ETF Rule.)
But not only do Vanguard ETFs typically follow passive, indexed strategies, the Vanguard brand name has powerful, deep market penetration among ETF and mutual fund investors alike.
Although active managers are clearly interested in these new nontransparent structures, it's less obvious whether ETF investors and advisors themselves are clamoring for less transparency in their portfolios, rather than more.
Contact Lara Crigger at [email protected]