Active ETFs – getting round the transparency problem

by , 7th February 2018

Active ETFs are still a very small part of the overall ETF industry but they’re being widely tipped for big growth to come. There’s one potential problem though – transparency.

One of the main selling points of ETFs is that they’re transparent. ETFs give frequent portfolio updates, often daily, and it’s easy for investors to see where their money is going. However, it’s a different story with conventional OEICs and unit trust, and at least some players in financial markets prefer a set up where updates are far less frequent.

What’s wrong with transparency?

A lot of the opposition comes from fund managers, especially if they manage equity funds. The managers worry that daily disclosure will enable other investors will copy their best ideas and also ‘front run’ them. In other words, if I know that a leading fund manager is building a stake in a relatively small company, I might buy shares myself as I’d expect the fund manager’s purchases to boost the share price. (Transparency is less of an issue for bond funds, simply because there are so many different bonds out there with different maturities.)

Market makers also dislike transparency. To ensure liquidity, they may have a significant number of shares in an ETF on their books. If they want to hedge the risk of holding those shares, they need to know what’s in the ETF’s portfolio.

The desire for transparency is even stronger if the market maker is also an authorised participant for the ETF. (Authorised Participants can create and redeem ETF shares.) If an authorised participant doesn’t know what’s in the ETF’s portfolio, it’s hard for it to create new shares in the ETF by offering shares in the ETF’s underlying investments.

Solutions

We’re now seeing  several solutions to the transparency problem emerging in the US. One is NextShares, which strictly speaking isn’t an ETF product. It’s an ‘exchange traded managed fund.’

These funds are similar to ETFs in that their shares are traded on an exchange during the trading day. But they’re like a mutual fund in that their price is set once a day, or at least their Net Asset Value is set once a day. When you buy shares in the fund, you pay the NAV plus or minus a premium/discount and that premium/discount moves around during the trading day.

So if you buy a share in the fund with a 2 cent premium, you’ll pay $20.02 for that share if the NAV at the end of the day is set at $20. It’s a little frustrating that you won’t know the exact price of the fund when you invest, but NextShares does offer three important advantages over conventional investment funds, advantages that are shared with ETFs.

Firstly, there’s no need for the fund manager to carry significant cash holdings because he doesn’t need to worry about keeping money for daily redemptions. Secondly, some of the costs of running a fund are lower and thirdly, investors at least have some idea of what the price will be when they purchase shares – in other words, they can estimate the NAV and know for certain what the premium/discount will be.

Several fund management firms in the US have launched funds that use the NextShares concept –  the idea of ‘NAV-based trading.’

Another option comes from Natixis and the New York Stock Exchange. Their idea is to maintain the ETF structure but at the end of the day, investors wouldn’t get an update on the ETF’s portfolio. Instead they’d see a ‘proxy portfolio’ that should simulate the daily return of the fund. That would enable market makers to hedge away their risk. Natixis filed for regulatory approval last month and we don’t know the verdict yet, but it’s certainly an interesting idea. The challenge may be to convince all stakeholders that the proxy portfolio will perform as expected every time.

A US firm called Precidian has another potential solution. It’s called ActiveShares, and it masks an ETF’s holdings by inserting a blind trust, known as a ‘confidential account’, between the fund and its authorised participants. This model also hasn’t received regulatory approval yet.

Why would you want an active ETF?

Many true believers see no need for active fund management, they’re happy to stick with traditional market-cap weighted passive funds as well as smart beta. If that’s your view, you don’t need to worry any further.

Some investors might say they do want to invest in active funds but don’t see any need for the ETF wrapper in this context. (Or a ETF-similar wrapper such as NextShares.) That’s also a perfectly reasonable view, but there are some good reasons to think that demand for active ETFs will start to rise.

That’s partly down to the advantages we’ve already touched on – less need for cash, and lower operating costs. But there’s also the point that newer investors may only be used to the ETF format, and if active managers want to attract younger customers to their products, they may have to adapt to the ETF format.

ETFs are taking market share from OEICs and unit trusts all the time. If fund management firms can’t get regulatory approval for new semi-transparent versions of ETFs, they may just have to accept that greater transparency is inevitable and launch active equity ETFs with daily updates. Perhaps that’s the most likely outcome.