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  2. EXCHANGE-TRADED FUNDS
June 29, 2020 12:00 AM

Managers begin turning their backs on transparency

Ari I. Weinberg
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    Ed Rosenberg
    Edward Rosenberg said RIAs are investing in American Century’s ETFs.

    Low cost, transparency and accessibility are the dominant themes that have propelled exchange-traded funds to more than $4.3 trillion in assets under management in the U.S. Largely built on broad-based stock and bond indexes, ETFs have myriad uses for investors across the spectrum. This "everyman" quality has attracted buy-and-hold investors, tactical traders, large institutions and, most recently, central banks, to build ETFs into the fabric of their investment process.

    But a host of money managers are now pushing back on the established structure, shunning indexes and daily transparency to offer actively managed ETFs that disclose their full holdings less regularly.

    Regulators long held that transparency was a critical aspect of ETF efficacy, allowing investors and market makers to make real-time judgments not only on fund price, but also on fund investments. Over the past year, however, the U.S. Securities and Exchange Commission approved five methods for offering actively managed ETFs that reveal their full portfolios only monthly or quarterly, while still attempting to provide the market with enough information to accurately price ETF shares intraday.

    On March 31, American Century Investments launched two ETFs using a structure developed by Precidian Investments. Under this structure, the fund publishes a "verified indicative intraday value" every second during market hours. VIIV is based on the basket of securities that the fund will accept or distribute for wholesale creations and redemptions of ETF shares. The basket is fully representative of the fund. Unlike other ETFs, however, the basket itself is not revealed to the market, but only to a representative of authorized participants that exchanges cash and securities with the fund.

    Though throwing new acronyms into a field with too many by half, Precidian's structure merges the tax efficiency of traditional ETFs with the proprietary security selection of traditional active management.

    The other four methods use a fully disclosed "proxy portfolio" to provide investors and market makers enough information to buy and sell the ETF, while shielding specific moves or actions by the portfolio manager and also preserving some tax benefits. Fidelity Investments launched three ETFs on June 4 using its proxy structure.

    With less than three months of trading, the American Century products have already gathered more than $200 million in assets, primarily from a $95 million creation in Focused Dynamic Growth and a $64 million creation in Focused Large Cap Value on June 5, according to ETF.com.

    Edward Rosenberg, senior vice president and head of exchange-traded funds for American Century, was not able to reveal the sources of the large flows though did indicate that the funds are seeing "flows from the independent registered investment adviser community that has fully embraced ETFs."

    "There's no better way to prove a product than to launch in a volatile market," Mr. Rosenberg said. Indeed, over its short life, Focused Dynamic Growth has handily beat its benchmark Russell 1000 Growth index while Focused Large Cap Value is largely in line with the Russell 1000 Value index, according to XTF.com.


    Dynamics also critical

    While performance is paramount for asset managers that have spent years wrangling legal and regulatory complexities to breach exchange trading, market dynamics are also critical.

    As expected, the products, regardless of structure or strategy, have traded at slightly wider spreads and higher premiums to net asset values than more transparent products. Trading has been muted as well.

    For example, Fidelity Blue Chip Growth, which has seen $8 million in net flows since its early June launch, has experienced an average spread of 19 basis points and a median premium of 20 basis points compared to large, liquid ETFs that see spreads and premiums hovering around 1 basis point.

    In line with other industry shifts, Greg Friedman, Fidelity head of ETF management and strategy, expects assets to increase over a longer time frame but believes that there is "pent-up demand by investors seeking excess returns to U.S. indexed strategies." And, as with all new products, he expects large institutional investors to wait for a track record before inquiring about the products.

    Ben Johnson, director of global ETF research at Morningstar Inc., said that relative merit of these ETFs compared to traditional open-end mutual funds and fully transparent active ETFs will primarily depend on "the investment content," acknowledging that the structures can offer "material improvements" in cost and tax efficiency, but that current restrictions on holdings tamp down "the opportunity set."

    The current approvals limit funds to U.S. equities, real estate investment trusts, exchange-traded commodities, futures, and cash instruments, including short-term U.S. securities and money market funds.

    In a regulatory filing earlier this year, Goldman Sachs Asset Management applied to broaden out the mandate of the Precidian structure in a multiasset income ETF that could include options, master limited partnerships and foreign common stocks "that trade contemporaneously with fund shares" as well as allow for the use of custom baskets. Currently, custom baskets, in which the assets offered for creation and redemption do not represent a pro rata slice of the fund, are only available to indexed and fully transparent active ETFs.

    GSAM also announced in May it has licensed the Fidelity structure as well. And BlackRock Inc. recently filed for approval of its FinTech ETF under the Precidian structure.

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