SEC Denies Precidian Active ETF Request

October 22, 2014

A brave new world of nontransparent active ETFs, for now, will have to wait.

U.S. regulators have denied a request that would allow so-called nontransparent active exchange-traded funds to be marketed in the U.S., putting on hold a multi-fund-sponsor initiative that many ETF industry analysts have said could alter the modern investment landscape.

To be clear, active ETFs already do exist in the U.S., but they are “transparent,” meaning their portfolio holdings must legally be disclosed daily. Conversely, the proposed non-transparent active ETFs would disclose portfolio holdings quarterly and, like mutual funds, often with a 60-day lag as well. Many firms have asked the Securities and Exchange Commission for permission to market such funds, including BlackRock's iShares, the world's biggest ETF firm.

The idea is that nontransparent active ETFs could be a way for portfolio managers to protect their best ideas and also to protect against the predatory front-running that can occur when transparent index ETFs make big portfolio changes.

At the core of the SEC’s reservations and rejection of the nontransparent active ETF petition filed by New Jersey-based Precidian Investments is a concern that the proposed mechanism to keep the market price of such funds in line with their net asset values is insufficient. That basically means that the SEC is worried that investors may not be able to pay the right price for what they buy when they buy such funds.

“The Commission preliminarily believes that it is not in the public interest or consistent with the protection of investors or the purposes fairly intended by the policy and provisions of the Act to grant the exemptive relief under section 6(c) that the Applicants seek,” the SEC ruling said.

That said, the SEC is entertaining public comments on its preliminary ruling. It said hearing-requests should be received by 5:30 p.m. ET on Nov. 17, 2014.

Lingering Questions

To be sure, the entire proposition that investors really want active ETFs—even the already-approved transparent-active ETFs on the U.S. market—is largely unproven. Less than 9 percent of the 1,640 ETFs now listed in the U.S. are actively managed.

More damning is that most of the 114 existing active funds have few assets. Those active ETFs have less than 1 percent of the $1.8 trillion now invested in U.S. ETFs.

Fixed income looms as one area of promise in terms of active ETFs. PIMCO, the world’s biggest bond fund manager, sponsors the two biggest active ETFs by assets. The biggest is the PIMCO Enhanced Short Maturity Strategy Fund (MINT | B). It has close to $4 billion in assets, or nearly one-fourth of all $16.7 billion now invested in active ETFs,  according to data compiled by ETF.com.

Part of the challenge for active ETFs is the rise of quasi-active “smart beta” ETFs in the past few years that are designed to beat market benchmarks around which the biggest and most successful index ETFs are often designed. Those assets now total at least $200 billion, or more than 10 percent of all ETF assets, and the pace of inflows into “smart beta” ETFs is twice that of inflows into ETFs in general.

Also, a body of rigorous data suggests that most active managers can’t reliably beat the indexes against which they benchmark, meaning it may not be worth the cost of even trying.

Moreover, the problem of unreliable outperformance is magnified when the passive versus active comparison is expanded to an entire portfolio organized with an eye toward thoughtful asset allocation.

 

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