Active fund managers will have to redraw battle plans in their years-long push to bring new products to exchanges after regulators delivered a public rebuke to two proposals for so-called “non-transparent” ETFs.
In a 60-page ruling on applications by BlackRock Inc. and Precidian Investments posted online Tuesday, the Securities and Exchange Commission said it was unlikely to allow those proposals to move forward.
Those two companies are among several vying for the opportunity to expand the reach of stock- and bond-picking mutual fund managers into exchange-traded funds, a lower-cost product structure increasingly popular with fee-based financial advisers and institutional traders.
Fund managers have engineered changes to normally open ETFs that would cloak the underlying strategies from prying competitors, but despite years of effort, they've been unable to convince regulators that those products can function as reliably as existing ETFs.
“It's back to the drawing board to come up with a model,” said Reginald M. Browne, an ETF trader at Cantor Fitzgerald.
Mr. Browne said the non-transparent funds have the ability to offer access to money managers looking to beat benchmarks at a lower cost than mutual funds and other types of products.
“This is a huge blow for active managers that want to launch in an ETF format, where they're seeking a model that will protect their I.P. [intellectual property] and will allow them to enter the ETF space,” said Mr. Browne. “More importantly, this is a setback for retail investors.”
The commission said approving the proposals in their current form was could “inflict substantial costs on investors, disrupt orderly trading and damage market confidence in … trading of ETFs.”
Despite the setback, the commission opened the floor to public comments through the middle of November during which time the applicants can continue to press their case. In addition, a number of proposals for similar concepts remain, including one by the Eaton Vance Corp. A reply on that proposal is due by Nov. 7. Eaton Vance declined to comment through spokeswoman Robyn Tice.
But the SEC's first lengthy analysis of the concept unearthed discomfort with the ability of the complex ecosystem that underpins ETFs to work normally with more opaque products, particularly in times of market stress.
ETF fund managers do not issue shares directly to ordinary investors. Instead, the market for those products depends on the activities of institutional traders, known as market makers.
With typical ETFs, the underlying holdings of both the index and the fund are disclosed to the general public, which helps market-makers manage the risk of arbitraging the difference in value between ETF shares and their underlying holdings. That arbitrage activity is supposed to keep the prices investors pay in close alignment with their actual value.
Jane Kanter, a former commission staff lawyer who now works as chief operating officer for New York-based ARK Investment Management, said firms will need to convince market participants that the proposal can work.
“If I were the applicants,” she said, “I'd probably work with the market makers in trying to come up with a way to give them the information they need to arbitrage properly and then I'd go back to the SEC with that in my pocket.”
The SEC has been polling those market-makers on non-transparent products in recent weeks and cited their concerns among the reasons for denying the request.
“The lack of portfolio transparency or an adequate substitute for portfolio transparency coupled with a potentially deficient back-up mechanism presents a significant risk that the market prices of ETF shares may materially deviate from the [net asset value per share] of the ETF — particularly in times of market stress when the need for verifiable pricing information becomes more acute,” the SEC said.
Despite the commission's critiques of their proposal, Precidian chief executive Daniel J. McCabe said the investment management industry supports the proposals before the SEC, and that he was optimistic that any outstanding issues could be resolved.
“These are things that can be worked though,” said Mr. McCabe in a telephone interview. “It's not a process that I enjoy, but when you do novel things, it takes longer than if you do standard things.”
BlackRock spokeswoman Melissa Garville declined to comment, but in a May interview with Bloomberg News, the head of BlackRock's ETF business, Mark Wiedman, said he was not optimistic the non-transparent products would be a big hit with investors even if they won regulatory approval.
ETFs, most of which track an index, have been the most successful asset management product over the last several years. There was nearly $1.7 trillion in U.S. ETFs at the end of 2013, up more than 1,000% from $151 billion in 2003, according to the Investment Company Institute, a Washington-based industry trade group.
Some industry watchers said the commission was motivated by a desire to protect investors who already struggle to understand the products they own.
“Investors don't know enough about the ETFs they do hold when the ETFs are transparent and so understandably the SEC has concerns about the risks investors will be taking on not fully understanding what they own,” said Todd Rosenbluth, director of U.S. ETF and mutual fund research at S&P Capital IQ, a research firm.
Ms. Kanter said market makers are largely wary of the “non-transparent” proposals and that the SEC's decision was only a surprise in that the tone was “a little bit harsher than I thought they would be.”
“People had a lot invested monetarily, emotionally and otherwise, so maybe it had to get to this point for people to understand that there was a problem,” said Ms. Kanter.