Will nontransparent ETFs attract the interest of advisors and investors that their creators are hoping for?
“We don’t know,” said Ed Rosenberg of American Century Funds, which hopes to introduce the first such ETF in the U.S. sometime this quarter. “Opinions don’t take shape until you go live.” Rosenberg was among several panelists at sessions focused on this new investment vehicle at the recent Inside ETFs conference in Hollywood, Florida.
Variations on the Theme
American Century is one of about 12 mutual fund companies that has licensed the ActiveShares structure for its nontransparent ETFs, also called semi-transparent ETFs because they do disclose their holders though to a more limited extent than traditional ETFs. Other asset managers that have licensed ActiveShares include Blackrock, Goldman Sachs, J.P. Morgan Asset Management, Gamco Investors, Nationwide, Capital Group and Legg Mason, which holds a minority stake in Precidian.
ActiveShares is the first of several nontransparent ETF structures to receive approval from the Securities and Eschange Commission and is the least transparent. It only provides daily disclosure of portfolio holdings to an unaffiliated representative of the authorized participants rather than to the authorized participants themselves, who are key to the creation and redemption mechanism that keeps ETF share prices aligned with their underlying net asset value. Investors will have to wait for quarterly disclosures with a 60-day lag, which is how most active mutual funds operate and most planned nontransparent ETFs expect to.
At the opposite end of the spectrum from the ActiveShares structure is Blue Tractor’s Dynamic structure, which has been licensed by The Nottingham Co., a service administrator for ETFs and mutual funds that helps bring white-labeled funds to market through its OBP Capital affiliate. Blue Tractor’s structure will disclose all the holdings of the ETF on a daily basis but only about 90% of their weightings.
“Knowing all the underlying names is important as people care more that the social values are reflected in their investments,” Blue Tractor Group founder Terry Norman told ThinkAdvisor. It may also be important to advisors. “Under Reg BI, can an advisor fulfill the obligation of acting in the best interest of clients without full transparency?” asks Norman.
Between these two models are myriad nontransparent ETF structures that use a proxy portfolio whose NAV closely matches the fund’s actual holdings. They include structures from T. Rowe Price, Invesco, Natixis (using NYSE methodology) and Fidelity. Actual fund holdings would be disclosed quarterly with a 15-day lag for T. Rowe Price, a 30-day lag for Invesco and a 60-day lag for Natixis and disclosed monthly with a 30-day lag for Fidelity.
All these nontransparent ETFs combine the tax efficiency of ETFs with the capabilities of an actively managed mutual fund, without the disclosure of the managers’ “secret sauce,” to protect against front running and copycats.
Not a Flood but a Trickle
When the SEC first approved the concept, giving the go-ahead to the AdvisorShares structure, there was talk about a flood of these funds coming to market. Now their creators and supporters expect a more gradual introduction.
Rosenberg expects no more than 20 such ETFs introduced this year with expense ratios in the range of 40 to 50 basis points (only T. Rowe has disclosed fees on its nontransparent ETFs, ranging from 50 to 57 basis points, contained in its SEC filing). The legal filing of such applications takes a minimum of 240 to 250 days since there are no generic listing requirements, explained Rosenberg.
What Will Investors and Advisors Do?
Whether investors and advisors embrace these structures remains an open question along with their distribution.
They provide more disclosure than actively managed mutual funds, which don’t reveal any holdings until usually 60 days after a quarter, and at a lower cost with more tax efficiency. But do investors really care about the reduced disclosure? They are probably more interested in the lower price and tax benefits, if they own mutual funds in taxable accounts.
There’s also the question of their liquidity, which will depend on their bid/ask spreads, and their tracking error versus benchmark indexes — all unknown until they start trading. “The investment content of active nontransparent ETFs will be king,” tweeted Ben Johnson, director of global exchange-traded fund research for Morningstar.
Distribution and Cloning Questions
Distribution is another question because investment platforms won’t be collecting fees like the 12b-1 fees they collect on mutual funds.
Nicholas J. Elward, head of institutional product and ETFs in the Strategic Product and Marketing Group at Natixis Investments, expects that many platforms will want to include nontransparent ETFs because they are a natural fit for the 42% of all mutual fund assets that are currently held in taxable accounts. Greg Friedman, head of ETF management and strategy at Fidelity Investments, noted that Fidelity is the only asset manager of this new fund structure that has its own distribution platform.
Then there’s the ETFs themselves. Will they be clones of existing popular mutual funds, which is what American Century is planning for at least a couple of these ETFs, or totally new products, which is Fidelity’s plan? Or will they be the reincarnations of some actively managed mutual funds that have been converted into a nontransparent ETF, which would create logistical issues for the fund manager as well as tax complications and possibly displeasure for some mutual fund investors?
Whatever fund companies choose, the launch of active nontransparent ETFs will attract new asset managers and mutual fund investors to the ETF market, said Brian McCabe, a partner in the asset management group at Ropes & Gray, noting that ETF assets, at roughly $4 trillion and mostly passive, are dwarfed by the $12 trillion in actively managed mutual funds.
Roughly half the active managers of mutual funds are working on developing a nontransparent active ETF, said Daniil Shapiro, associate director, product development at Cerulli Associates.
A recent Broadridge survey of 200 financial advisors with at least $10 million in assets under management found that that 85% of financial advisors are likely to allocate assets to active nontransparent ETFs, with more than four in five advisors currently hoping their favorite active mutual fund becomes available in a nontransparent ETF structure.
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