Does Active ETF Transparency Matter?

Active semitransparent—or nontransparent, as some call it—ETFs are finally here. The launch of American Century’s two ETFs late last week built around the Precidian ActiveShares model ended our long wait for this new wrapper, opening the door for what many expect to be a turning point for actively managed ETFs.

But will they improve investor outcomes, and really change the game for the ETF market? Only time will tell.

The buzz has centered around the issue of portfolio transparency, or in this case, the lack thereof. These new ETFs only periodically disclose holdings, once a quarter, which is the most black-box approach so far in an ETF—a crucial distinction from the daily transparency we’re used to having in the ETF space.

Departure For ETFs

Quarterly portfolio disclosures are common practice in the active mutual fund space, but they’re a departure from one of the ETF structure’s most heralded attributes: daily transparency.

That’s not a trivial difference. The semitransparent design has required (in some models of this wrapper approved by the Securities and Exchange Commission) the addition of another player in the creation/redemption process so that opacity of holdings is guaranteed. Not even authorized participants—those creating and redeeming ETF shares to ensure supply is elastic to meet demand—will know the stocks that go into these portfolios.

One of the arguments for this vehicle is that, alas, front-running fears will be gone, be they real or imagined. The secret-sauce recipe to achieving alpha is now protected, and yet accessible in an ETF wrapper.

We Want To Believe

We know we all want to believe in the power of expertise; in the persistence of performance; in the idea that we can beat the market.

Historical performance data tells us it isn’t so. Any SPIVA U.S. Scorecard will show us that most active managers fail to beat their benchmarks, and the ones who do, fail to repeat that performance consistently. To that point, SPIVA’s most recent report shows that in 2019, 71% of active large cap funds lagged the S&P 500. Over a 10-year period, 89% of them trailed the index.

Can active management work? Of course it can. We’ve seen it work in ARK Invest’s active ETFs, often ahead of the curve, hand-picking disruptive technology stocks many see as contrarian bets at times. ARK ETFs such as the ARK Innovation ETF (ARKK) and the ARK Genomic Revolution ETF (ARKG) have beaten the odds more times than we can count. Their strongr returns impress most of the time, and they've done it with ample portfolio transparency.

We’ve seen it in Cambria’s quant approach to the Cambria Tail Risk ETF (TAIL) this year, one of the best-performing active ETFs in 2020, offering a hands-on portfolio built for downside protection. It’s been a good year for TAIL, up 27% year to date.

We’ve seen it work in fixed-income to mixed results, the asset class expected to offer ample opportunity for alpha due to its difficult access, illiquidity and massive size.

The Struggle Is Real

But we’ve also witnessed the struggle, as SPIVA data shows, even among the biggest, most battle-tested asset managers out there. Consider a pair of Vanguard value-factor ETFs as an example.

The Vanguard U.S. Value Factor ETF (VFVA) is an actively managed portfolio that tries to outperform the market by investing in stocks whose share prices are low relative to their fundamental values. The Vanguard Value ETF (VTV) is a passive large cap value stock fund tracking the CRSP US Large Cap Value Index.

Year to date, VFVA is down 43%. VTV is down 26%. That’s a 17 percentage point underperformance for a value portfolio that costs 0.14% a year in expense ratio—more than three times the VTV fee.

VFVA Vs. VTV

Chart courtesy of StockCharts.com

The Challenge At Hand

This pairing is one randomly selected example, and limited in scope. It offers a snapshot of performance in a very short-term window. It’s hardly an indictment against VFVA’s track record. But it illustrates the challenge at hand—active management, costlier, often fails to deliver outsized gains to justify their fee. (The semitransparent American Century Focused Dynamic Growth ETF (FDG) and the American Century Focused Large Cap Value ETF (FLV) charge expense ratios of 0.45% and 0.42%, respectively.)

Do we need to give up portfolio transparency to find consistent success in actively managed ETFs? Do less transparent ETFs solve an investor problem? It doesn't look like it. But these new funds could be game changers by solving an asset manager’s problem, which is their clients asking for ETFs—cheaper, tax efficient, tradable ETFs.

ACI’s launch, and the many that are expected to follow, clears the way for big, well-known active managers who have thus far shied away from the ETF structure due to the transparency requirement. For die-hard active investors, chances are believing in your manager's expertise is more important than knowing every single day what's in your portfolio. It could be that opacity of portfolio holdings opens the doors for these managers and their clients to enter the ETF fold, bringing a whole new wave of growth to the maturing ETF market.

Or so the theory goes.  

Today actively managed ETFs account for just about 2.5% of total U.S.-listed ETF assets. It's a segment that has struggled to find much traction. Only time will tell whether active nontransparent ETFs will bring a new following into the ETF market and potentially improve investor outcomes. For now, what we can say is that we love disruption that expands investor access to markets, so while we wait for what happens next, we're excited to see ACI kick off this new race.

Contact Cinthia Murphy at [email protected]