Many ETF purists will be clutching their pearls at the thought. After all, we've been told for so long that ETFs are simple, transparent, index-tracking funds. Isn't the very idea of a non-transparent ETF anathema against everything that ETFs are supposed to stand for?
No. Far from being an almost treacherously revolutionary concept, the introduction of NTAEs should be viewed as a natural, healthy and desirable development in the evolution of a European ETF industry - an industry which has a proud track record of embracing the future, supporting innovation and encouraging experimentation.
First generation ETFs provided exposure to mainstream capitalization weighted indexes, but there was nothing to fix this as a limit to their potential. ETFs quickly evolved away from tracking vanilla indexes to cover a huge range of smart beta and multi-factor approaches that mimicked popular active management strategies. The rapid growth of these new approaches demonstrated that ETFs are a technology that is highly effective in the distribution of investment ideas, rather than being an index or asset class specific proposition. The fact that the first ideas that were effectively distributed as ETFs were index portfolios is almost entirely irrelevant.
Why are ETFs Transparent?Go to any ETF conference and you will hear a speaker extolling the well-established benefits of ETFs - cost efficiency, liquidity, diversification and transparency. Daily disclosure of portfolio holdings and weights is rightly touted as an attractive feature of ETFs, but it is more of a happy side-effect than a deliberate design decision.
ETFs are transparent due to the mechanics of intra-day ETF trading - a market maker wants to provide the tightest spreads on a given ETF. To do that, they need to be able to accurately price the fund, with confidence. Therefore, they need the know the exact composition of the fund, hence full holdings including cash and weights were required every day in the Portfolio Composition File (PCF) - anything less means a market maker needs to widen their spreads to adjust for the uncertainty. The PCF as a tool is rarely asked for or provided to end clients which demonstrates the point that this disclosure tool is not used for transparency by end investors.
Is transparency important?Transparency was never designed to be a market disclosure service, but the consensus is that investors nonetheless value transparency of ETFs. This may be true, but in more than 15 years of building ETF businesses, I have only ever had five clients ask me for a PCF file. I sent it to them and they never asked twice. Transparency is only useful if you are going to do something with it and many investors don't know what to do with transparency once they have it. Perhaps the idea of transparency is more important than the transparency itself?
Most European mutual funds, active or passive, tend to disclose only their top 10 holdings on a monthly basis and no one bemoans that. The additional transparency that is currently required for ETFs does not seem to be used in making investment decisions by end investors.
Limited disclosure has been the norm for the majority of mutual funds sold to institutional and retail investors across Europe under UCITS and has never curtailed the funds ability to raise assets or satisfy regulatory requirements. As ETFs are UCITS, why should they be held to different standards than any other UCITS fund?
Why active asset managers are 'active-ating' their ETF strategiesCreating an ETF strategy is among the highest priorities for many asset managers - 67% of respondents to the EY Global ETF Survey expected a majority of asset managers to have an ETF offering in the near future. Asset managers are recognising the business opportunity of participating in an industry that saw growth of over 40% in 2017 and are seeking to develop an ETF range which they can offer alongside other structures like mutual funds, structured products, separate managed accounts or investment trusts, providing an alternative channel through which their investment ideas can be bought.
Just as a coffee company can sell their product as beans, ground coffee, pods, instant powder or pre-mixed iced coffee, so can an asset manager add to their distribution firepower by adding an ETF category to their product range. Many will already offer multiple wrappers including mutual funds, hedge funds, structured products and so on. Adding ETFs is simply extending this foot print.
Re-imagining a product range to include ETFs enables asset managers to position themselves to benefit from the ever-increasing number of ETF-focussed platforms and distributors: there are now over 100 robo-advisers in Europe and many retail brokerages, wealth managers and banks are now offering ETF-based model portfolios. ETFs allow access into this space and as importantly, provide a much smoother path to enter foreign countries that may be key to long-term business growth. For example, UK, Germany, France, Italy, Spain, Nordics and Holland all have strong domestic ETF markets and the ability to list ETFs domestically.
Without an ETF range, asset managers risk being excluded from these important distribution channels and will be at a significant competitive disadvantage to managers who recognised the distribution potential of ETFs earlier on.
The creation of non-transparent active ETFs could unleash a wave of innovation and growth within the ETF industry, but more importantly, there are also tremendous benefits for the end investors across Europe.
In the final article in this series, HANetf will explore how investors could be the biggest beneficiaries of this change and how concerns around disclosure and transparency can be addressed.