From the October 2015 issue of Investment Advisor • Subscribe!

Non-Transparent Active ETFs Are Coming

Some ETF providers are already shielding their proprietary methodology with non-transparent practices

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Non-transparent active ETFs might be operated similarly to index-based ETFs whose holdings are kept secret. Non-transparent active ETFs might be operated similarly to index-based ETFs whose holdings are kept secret.

As a sponsor of transparent actively managed ETFs, as well as a staunch proponent of transparency in general, I believe that the SEC will eventually approve non-transparent active ETFs.

I am not referring to the exchange-traded managed fund (ETMF) structure, a new type of exchange-listed, non-transparent investment product for which Eaton Vance received SEC approval last year to offer. That product structure will require a significant amount of infrastructure development and education before it can come to market.

However, a true non-transparent actively managed ETF could easily fit into both the brokerage and exchange-traded infrastructure that exists today. An unusual Freedom of Information Act (FOIA) request submitted by Eaton Vance for an SEC comment letter regarding Precidian's application to offer non-transparent active ETFs indicated that the SEC is focused on one main issue: How can that type of ETF be efficiently priced?

Interestingly enough, Vanguard today operates its index-based ETFs lineup in a non-transparent fashion. Many may be led to believe that because ETFs track an index, then the underlying constituents are fully visible and updated on a daily basis. Vanguard shields its ETF holdings — reporting portfolio information at month-end with a 15 day-lag — because they take an “optimized” approach to replicating the index, which allows them to keep their proprietary methodology a secret.

With this cloaking of transparency, how do market makers effectively make markets and address any slippage in this non-transparent optimized process? If AUM growth is any indicator, most investors believe Vanguard ETFs trade very efficiently. Thankfully, the operation and trading behind these ETFs all run smoothly. However, the reality is that Vanguard could get it wrong (although probably not by a significant margin), as could anyone else.

The first sign that would make a market marker wonder about mispricing would be reflected in the net asset value (NAV) calculation at the end of the trading day. Most market makers calculate their own indicative values anyway, and if they recognize a discrepancy in an ETF's market price, they can easily make any minor adjustments necessary and ensure continued efficient trading.

A similar process would appear applicable for non-transparent active ETFs. An authorized participant (AP) or market maker would create a tracking basket, not too unlike an index, while near real-time indicative values can be disseminated. According to Precidian's exemptive relief application to the SEC, market makers would utilize a confidential trust to facilitate the in-kind transaction for the non-transparent active ETFs’ actual underlying holdings. Similar to Vanguard's non-transparent index ETFs, market makers would know quickly if something was off, either throughout the day via the dissemination of the indicative NAV, as well as from the NAV struck at the end of the trading day.

Just as the SEC completed a thorough educational process in understanding fully transparent active ETFs, they are likely in the final stages of completing similar steps before an approval of non-transparent active ETFs. With such approval, the real benefit for investors ultimately will be the fact that they can leverage their current understanding of how ETFs operate as opposed to learning the nuances of a brand new product structure.

While I firmly believe transparency is better for advisors and investors alike, I also understand there are some portfolio managers who, if they were to offer their strategy in a non-transparent active ETF, could find enough investors who would likely support it. As an industry, we have yet to witness a situation where non-transparency improves alpha, but we have seen that advisors can still deliver both alpha and full transparency in client portfolios. Regardless, moving more investment assets to the more efficient structure of ETFs would naturally be a positive step for investors.

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