The case for non-transparent ETFs, part one

Hector McNeil

a man in a suit

In the first of three articles running over the course of the next three weeks, Hector McNeil, the co-founder and co-chief executive at independent white-label provider HANetf discusses why he believes there is a case for non-transparent ETFs.

Growth in the ETF industry is sustained, long-term and global - at the time of writing, there have been 51 months of consecutive net inflows to the industry. This expansion is being sustained by both internal innovation and external mega-trends but the ETF industry is also seizing the opportunity to rapidly innovate and drive growth from the inside: creating, marketing and distributing new investment propositions that go far beyond the scope of what the original ETF pioneers could have imagined.

At HANetf we believe that ETFs are simply a wrapper and should not be defined by the strategy they follow. ETFs are just better 'tech' - the iPhone to the mutual fund's Filofax. It is our view that in 15 years all new funds will be ETFs that can be traded throughout the day and any remaining mutual funds will need to look and feel more like ETFs in order to survive and retain legacy assets.

Active ETFs, in particular, are one of the most significant growth opportunities but are a segment of the market that is controversial, poorly understood and, in Europe, subject to inconsistent regulatory treatment. Active ETFs are a small portion of the existing ETF markets in both North America and Europe - data supplied by IHS Markit shows that only 1% of AUM (US$49bn) is invested in Active ETFs compared to an overall market of US$4.5trn. While the assets are small, the growth is strong. Active ETF AUM grew by 57% between January 2017 and June 2018 with 91 new active ETFs coming to market in the same period.

ETFs have won the war for basic index exposure. Tomorrow's battle grounds are thematic, smart beta and ultimately active strategies. It's clear that the supply of transparent ETFs is growing. However, it is also clear the industry needs a solution for non-transparent ETFs to allow the active equity ETF world to flourish.

Favouring Fixed Income

A significant proportion of active ETF launches have focussed on fixed-income strategies. This is unsurprising given under existing rules ETFs must publish their full portfolio holdings and weights every day and this is generally less of a concern for fixed income strategies. Active equity managers are concerned about the risk of front-running eroding their edge and destroying the value of their investment strategy and hence the requirement to publish full holdings on a daily basis represents a significant challenge to them.

Fixed income, where there are potentially many different bonds for a given company, all trading over-the-counter, carries a far lower risk of front running and has been more rapidly embraced by active managers with an ETF shaped twinkle in their eye.

This imbalance in issuance of active equity and fixed income strategies reveals a tension at the heart of the industry which, if resolved, could fuel the next wave of ETF market growth, competition and product innovation. It all comes down to disclosure requirements versus secret sauces.

The value proposition of an active manager is that they have unique and specialist insight into certain markets or asset classes which enables them to outperform the market - the infamous "secret sauce". In return for outperformance the asset manager can charge a premium fee. If the manager is forced to reveal the recipe and ingredients to their secret sauce, then their value may disappear along with their business.

Ultimately as an industry we are duty bound to extend the ETF revolution beyond passives and bring our efficiencies to the active management world.

We believe this unresolved tension is inhibiting growth in the European ETF markets, reducing competition and unnecessarily limiting investor choice.

In the next article, HANetf will examine a potential solution already being offered to US and Canadian investors: the non-transparent active ETF.

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