You’ll be hearing more about “nontransparent” exchange-traded funds, now that the Securities and Exchange Commission is poised to approve a wave of them.
ETFs are known for being transparent, in the sense that they generally disclose their holdings daily. Nontransparent ETFs are a new category that will allow asset managers to actively manage a fund, as mutual-fund managers do, without having to disclose all of the fund’s investments every day. The idea is that nontransparency will allow active ETF managers to pursue their investment strategies without the risk that they will be foiled by the market’s reactions or copied by others if they have to reveal every move they make.
Active managers say nontransparent ETFs will allow them to offer the potential benefits of active management with the cost and tax advantages of ETFs. But the lack of transparency has created concerns about how accurately these funds’ share prices will reflect the funds’ holdings on a daily basis.
The question of clarity
In April, the SEC approved an application from Precidian Funds LLC for a nontransparent ETF structure called ActiveShares. Precidian is partly owned by Legg Mason (LM), which is licensing the structure so that it can offer funds based on it. Fund providers American Century, BlackRock (BLK), Capital Group, Columbia Threadneedle, Gabelli, JPMorgan (JPM) and Nuveen have all signed on to license ActiveShares, indicating a wave of ETFs to come based on the structure.
Other providers also have filed for SEC approval of nontransparent ETFs. The core focus of the SEC in relation to these funds has been on intraday pricing and how positions are eventually disclosed.
“There is a concern about the ability of market makers’ ability to quote accurate prices if they don’t have a clear picture” of a fund’s holdings, says Ben Johnson, director of global ETF research for research firm Morningstar Inc.
ActiveShares uses an authorized intermediary to provide daily information on holdings to market makers, without making that data available to the general public. “Our structure ensures that authorized purchasers have all of the information they need to make markets and limit risk,” says Daniel McCabe, Precidian’s chief executive. “We also provide updated intraday pricing every second, so the product behaves and should be treated like any other ETF.”
The other companies that have filed for approval of nontransparent ETFs rely on various methods to get data on their holdings to market makers, but Mr. Johnson notes that it’s hard to tell at this point how seamless that process will be.
Another concern has been that providers will have to work closely with broker-dealers and financial advisers to help them understand how the funds work. “One of the big obstacles here will be the complexity,” says Jeremy Held, director of research at SS&C ALPS Advisors.
Mr. Held adds that while investors may not be fully dialed into the debate over the structure of nontransparent ETFs, they are likely to focus on the lack of transparency. These funds will be under pressure to demonstrate a clear benefit to portfolios that outweighs delayed disclosure of their holdings—especially for investors who aren’t already in actively managed funds. Nontransparent ETFs will also be going head-to-head against a growing number of transparent active ETFs with established track records.
The irony of ‘active’
“One of the ironies here is that a major driver of growth in the ETF space has been the underperformance of active management, which pushed investors to seek lower-cost and easier-to-understand options,” Mr. Held says. Indeed both WisdomTree (WETF) and Charles Schwab (SCHW) have expressed skepticism about nontransparent ETFs to reporters and analysts on recent earnings calls, citing lack of transparency and performance concerns as key issues.
For investors who are already in actively managed mutual funds and are therefore comfortable with a little less transparency, asset managers are betting that the transition to opaque ETFs will be straightforward.
However, Nick Elward, senior vice president and head of ETFs at Natixis Investment Managers, says investors will want to look closely at the tax implications before moving any money from mutual funds to nontransparent ETFs. Mutual-fund investors may take a tax hit from realizing unexpected capital gains when they sell their shares. The benefits of switching over will have to outweigh those initial costs.
“These products certainly give investors more choices for active management,” Mr. Elward says. “But it will be incumbent upon managers to prove the benefits and that they can outperform consistently. Investors are usually willing to trust if the track record is there.”
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