Nontransparent Active: Next ETF Revolution?

Are nontransparent, actively managed ETFs the Next Big Thing in ETFs?

Potential product issuers certainly hope so. But though proposals for nontransparent, actively managed ETFs have been in front of the SEC for years, to date, only two versions have launched.

The first, by Vanguard, is also a bit of an exception: Not only are Vanguard ETFs simply share classes of pre-existing mutual funds, they're not actively managed. It's true that holdings in Vanguard ETFs are only disclosed monthly, on a 15-day lag; but most of their funds are based on passive indexes, whose constituents are publicly accessible.

The second model, NextShares by Eaton Vance, is truly a nontransparent, actively managed vehicle. But it has yet to take off with investors; the 18 NextShares exchange-traded managed funds have only gathered $153 million in assets under management (AUM), after more than two years of trading (read: "Eaton Vance's ETMF Finally Debuts").

These two structures and the five proposals still before the SEC are the subject of a new white paper by ALPS' (recently acquired by SS&C) Nichole Kramer and Casey Kayl, titled "Non-Transparent Exchange Traded Products: A Revolution 25 Years In The Making."

Kramer and Kayl, who are ETF supervisor and senior ETF analyst for ALPS's Intermediary Services division, respectively, compiled their research over three years. They combed through SEC filings and interviewed dozens of product issuers, authorized participants, market makers and investors. (ALPS has an existing licensing agreement with NextShares.)

Although the research paper itself is comprehensive, ETF.com reached out to Kramer and Kayl to discuss some of the findings that the two authors couldn't quite fit into the final version.

ETF.com: Most of the nontransparent active ETF structures proposed have not yet been approved by the SEC. Why has the approval process taken so long, and which, if any, have a good shot of getting approved next?

Nichole Kramer: I think one of the biggest reasons there's been a hang-up is that you've seen so much discourse about each of the filings. We don't normally see people comment back and forth about whose model is better. I think that was a little surprising!

But I do think they’re close. What may happen with the SEC—which we really hope it does—is that it'll approve more than just one. Then I think the market will determine who has the best model. But you need to put more than one out there in order to determine that.

ETF.com: We do have NextShares already.

Kramer: True, but we haven't seen as much traction on the NextShares. As we were doing final edits on the paper, we watched the AUM [in NextShares products] drop considerably, from $160 million to $153 million. There just hasn't been the traction [in them] we've seen with normal ETFs. So, let's put out a different model and see which really is the best.

ETF.com: Why do you think investors haven't embraced the NextShares nontransparent active ETF model, especially when you figure the Vanguard nontransparent model has hundreds of billions in AUM to date?

Casey Kayl: That’s a great question. We really don’t have a really good answer, to be honest.

Kramer: Well, Vanguard is passive. Even though there's only 80% visibility [into their portfolios], market makers still can figure out what they need to do to arbitrage without front-running, because it’s based on a passive index.

So maybe NextShares haven't taken off for the same reason as any other ETF: Maybe [investors] don’t like what the underlying holdings are. It's like anything else: You've got to have the right holdings and the right strategies. It's got to work in the market.

ETF.com: The basic premise of a nontransparent ETF will turn off some investors, too; or at least make them wary. Do you think that's playing a role, too?

Kayl: We haven't seen that in the open-ended mutual fund space. That's a nontransparent model, and those active strategies have billions in assets. So I don't know if that's necessarily what's driving it. As an investor, I don't know how much you'll miss daily portfolio transparency, if you're used to an open-ended mutual fund, where you're not seeing that anyhow.

ETF.com: So all these models are really for converting existing mutual fund investors, versus trying to lure investors back from ETFs.

Kayl: Yes.

Kramer: This is a bridge between mutual funds to ETFs, a way to put me [the investor] in the middle of them. If you think about all the outflows we've seen from mutual funds to ETFs … if I'm a mutual fund issuer, I'm trying to figure out a way to revitalize my business. What can I do? Well, these are six possibilities. Why wouldn't I want to look at each of them and see how my model might work with them?

ETF.com: The benefit of a nontransparent active ETF to active managers and product issuers is fairly straightforward. What's the net benefit to the end investor? Does it come down to cost?

Kayl: Since we haven't seen any of them approved, I'm not sure where we'd fall on underlying operating costs. Obviously, that's a big draw of ETFs, compared to open-ended mutual funds, but without seeing an actual product in place, I don't know.

Being able to harness the tax efficiency that comes through the creation/redemption process benefits investors. A lot of these products operate with a creation/redemption mechanism, reducing the burdens on the end investor that are involved in redeeming open-ended mutual fund shares.

ETF.com: At the same time, many of these structures have extra steps built into them: a secondary proxy creation basket, or an extra middleman between the AP and the portfolio. Will this all add up to higher costs for investors?

Kramer: It's hard to know what the transfer agencies and custodians are going to have to build out. We're looking at all those things for our next paper.

ETF.com: If and when these vehicles get approved, for which kinds of investors would be they be best suited?

Kayl: I think the targets are existing, open-ended mutual fund investors, who would see possible alpha generation from active management. I don't see any reason [to use these structures] if you're a passive, low-cost, asset-allocation-oriented investor, who's just looking to reduce the fees associated with long-term investing. I don't know that you'd be interested in products like this. But those who are tired of dealing with the drawbacks of traditional open-ended mutual funds would be my guess.

Contact Lara Crigger at [email protected]