The exchange-traded fund market is defined by transparency and disclosure. But a nearly decadelong effort to redefine those aspects of the market has finally crossed the finish line at the U.S. Securities and Exchange Commission.
The SEC on May 20 signed off on an order that would allow Precidian Investments LLC to offer an actively managed ETF that wouldn't be required to disclose its full portfolio to the market on a daily basis.
The Precidian structure, branded ActiveShares, would provide disclosure only to a broker acting as an "authorized participant representative" that either buys or liquidates the portfolio basket in exchange for cash. The ETF itself would publish the basket value every second of the trading day, as opposed to every 15 seconds for existing ETFs.
A handful of ETFs from Legg Mason Inc.'s Royce & Associates and ClearBridge Investments, which were listed as initial funds in the Precidian filing, can now start filing for an exchange listing.
At the core of Precidian's application is a system that preserves the arbitrage mechanism that keeps ETF prices in line with net asset value per share, while forgoing the requirement for daily disclosure of the fund portfolio and/or the basket of securities needed to create or redeem shares with the fund. Any arbitrage to be captured from the price differential of the basket and the ETF is a critical component to ETF flows.
The in-kind exchange between the fund and the authorized participant helps both index and transparent active ETFs keep capital gains distributions to a minimum. The application only allows for a fund to hold securities that trade contemporaneously with the ETF, including U.S.-listed stocks, American depository receipts, real estate investment trusts, other exchange-traded products, metal trusts, commodity pools, futures and cash.
"We are looking to evolve the marketplace for active management into a more efficient structure," Precidian CEO Daniel McCabe said in an earlier interview.
According to Morningstar Inc., the opportunity set among U.S. mutual funds that hold only domestic equities is vast. As of May 14, there were 2,010 funds collectively holding $4.4 trillion with a median expense ratio of 0.96% and an asset-weighted expense ratio of 0.72%.
Legg Mason, an investor in Precidian with an option to take majority control, is a current licensee of the structure, as are J.P. Morgan Asset Management and American Century Investment Management Inc., among others.
An alternative to the Precidian structure has been offered by Eaton Vance Corp. since 2016. Exchange-traded managed funds, as they are called, focus more on the tradeability of fund shares and have $1.05 billion in assets across 11 funds from five issuers, according to research firm XTF Inc.
While actively managed fixed-income ETFs, particularly for loans and shorter maturities, have seen some success ($57.6 billion in assets), active equity managers have been slow to embrace the full transparency required by existing ETF regulations. Some, however, have jumped in feet first.
"This is about client choice. Our clients asked for these offerings," said Dodd Kittsley, director of ETF strategy at Davis Selected Advisors LP in New York. "And our portfolio managers find tremendous value in the ETF structure because it allows them to preserve the portfolio's true north rather than managing to cash flows," Mr. Kittsley said.
Davis currently lists four transparent active funds with $665 million in assets under management.
On the other hand, Edward Rosenberg, Chicago-based senior vice president and director of ETF strategy for American Century Investments, also sees ActiveShares as providing choice. The Precidian-licensee currently offers five ETFs, including two active fixed income funds. While long-term, low-turnover active equity strategies may see little challenge in daily portfolio transparency, concentrated and high-turnover strategies could be more susceptible to front-running, Mr. Rosenberg said.
Following the ActiveShares approval, American Century filed with the SEC to offer two funds using the structure.
The expectation that Precidian's application approval will cascade a listing process for a live product on a securities exchange has had the legal community piecing out how existing open-end mutual funds could convert themselves into ActiveShares. (Seven years ago, the former Huntington Asset Advisors failed to win approval for an ETF conversion.)
Brian McCabe, a partner at law firm Ropes & Gray LLP in Boston, said that the application has opened up new conversations with asset managers looking to bring their active strategies to the ETF market. "How these funds would convert, by board or shareholder vote, ought not to be much of barrier," said Mr. McCabe, no relation to Precidian's Mr. McCabe.