Benefit and future of non-transparent ETFs uncertain

Pressure is building behind the dam to release a new kind of exchange-traded fund into the world, yet many observers continue to ask: “Who benefits?”

Recent regulatory activity around non-transparent actively managed exchange-traded funds has market observers wondering if a long-anticipated innovation in fund distribution may soon be available for purchase.

Currently, actively managed ETFs are required to disclose all holdings daily. Index ETFs are not required to disclose, but most do.

Yet, these new breeds of active ETFs have been designed to appeal specifically to intermediaries and retail customers — essentially leveling the distribution playing field for active managers who would otherwise sell direct, through advisers or on platforms. But the availability of traditional active strategies on exchanges may be less interesting to institutions, which are more likely to manage assets internally or hire third parties running separately managed accounts.

“These structures were built to protect portfolio managers. But what is the investor getting out of it?” asks Richard Keary, founder of New York-based Global ETF Advisors LLC, which consults with asset managers and portfolio managers on setting up ETFs. Multiple “technologies” are in place to bring these funds to market, but the ultimate barrier lies with the Securities and Exchange Commission division of trading and markets, which must approve any rule changes by securities exchanges to list the new products. Both NYSE Arca and Nasdaq Stock Market have rule proposals before the SEC for such listings. Following an initial comment period, both have moved to formal proceedings.

At NYSE, the rule would accommodate the listing of new ETFs from Precidian Investments, a Bedminster, N.J., company whose patented “ActiveShares” structure has received votes of confidence from several major asset managers, including BlackRock (BLK) Inc. (BLK) and State Street Global Advisors, which have made filings that propose funds with a similar structure.

In late July, Los-Angeles-based Capital Group, which manages $1.2 trillion for American Funds, threw its weight behind this strategy in its first ETF filing. 

“We've made no final decision to offer exchange-traded funds,” said Capital Group spokesman Chuck Freadhoff. “Any decision will be consistent with our long-standing commitment to the role of the financial adviser.”

Mr. Freadhoff added that the regulatory filing will allow the firm to “have a more substantive dialogue with the Securities and Exchange Commission as well as broker-dealer firms about the viability of actively managed, non-transparent ETFs.”

Precidian's structure keys on setting up blind trusts between authorized participants and the fund itself. Generally, authorized participants handle exchanges with the fund directly using cash or securities. A blind trust would allow the fund to redeem securities and liquidate them in an orderly fashion, while bestowing on an active strategy the ability to disclose its portfolio quarterly and shed low-basis securities to reduce capital gains.

“In our talks over the past seven years with some of the largest asset managers in the world, there are as many solutions as managers,” said J. Stuart Thomas, principal at Precidian.

Mr. Thomas said that managers could offer an ETF as an alternative to an existing strategy, start from scratch, or even attempt to convert an existing traditional fund.

While other structures have been proposed, another concept moving along the regulatory calendar is championed by Navigate Fund Solutions, a unit of Eaton Vance (EV) Corp., Boston. Nasdaq has filed for a rule approval to float exchange-traded managed fund shares and recent registration statements indicate the company would offer ETMFs advised by Eaton Vance Management (EV), as well as subadvisers Richard Bernstein Advisors LLC and Parametric Portfolio Associates LLC.

An Eaton Vance spokeswoman said that the registration statements were filed “in the normal course of preparing to rely on the exemptive relief we have requested that is before the SEC for consideration.”

ETMFs would use NAV-based trading, which allows orders to be placed throughout the day at levels above, below (or at) end of day NAV.

In March, Euronext began offering a set of ETFs for NAV-based trading. “The potential for non-transparent actively managed ETFs for institutional investors is limited,” said Ben Johnson, global director of manager research for passive strategies at Morningstar Inc., Chicago.

“Cost savings doesn't hold up, nor does the argument for improved tax efficiency ... and even the accessibility argument is not compelling.”

According to Morningstar, index ETFs and mutual funds accounted for 68% of fund flows in the 12 months ended June 30.

This article originally appeared in the August 18, 2014 print issue as, "Benefit and future of non-transparent ETFs uncertain".