Active managers are being confronted by a number of difficult headwinds. Since the crisis, a combination of volatile markets; increasing regulatory supervision and investor pressure on fees have been steadily chiselling away at the industry’s profit margins. Escalating matters further is that active managers are facing growing competition from low fee investment products such as passive funds, many of whom have actually delivered better performance. As a result, active managers have been haemorrhaging assets as capital is increasingly redeployed into passive investment strategies such as exchange traded funds (ETFs).1
Due to this widespread rebalancing of flows, Moody’s predicts the volume of assets controlled by passive funds will surpass active asset managers from 2021,2 although Morningstar suggests this shakeup could happen much earlier, potentially even this year.3 Other providers give a more conservative outlook, most notably PwC, which estimates that assets in US passive funds will reach a parity with actively managed products in 2025. 4
Drilling down non-transparent ETFs
In response, active managers are going on the offensive, as they look to identify new products and strategies to help them preserve market share. It is here where non-transparent ETFs could play a big role. A non-transparent ETF is an actively managed ETF, which is permitted to report details about its holdings on either a monthly or even quarterly basis. 5 In contrast, passive ETFs ordinarily disclose information about the composition of their portfolios or, more accurately, a single basket of stocks (representing the smallest trade size for creations/redemptions at a fund level) on a daily basis. This information is used to generate an indicative Net Asset Value (iNAV) every 15 seconds to ensure that a fund can be accurately priced by primary market participants throughout the day.
Non-transparent ETFs were given the seal of regulatory approval in the US back in April 2019 when the Securities and Exchange Commission (SEC) authorised ActiveShares, a proprietary technology created by Precidian Investments. ActiveShares replaces the traditional approach of disclosing an ETF’s portfolio to the market on a daily basis and instead inserts a black box between the issuers and market participants enabling the fund to be priced accurately at high frequency (i.e. every second) while simultaneously ensuring that details about the specific portfolio composition are kept hidden6.
To some commentators – particularly those with a passive ETF background, the idea of allowing ETFs to become more opaque appears counterintuitive and regressive. However, other industry experts have argued that the original purpose of the daily portfolio composition file was to enable primary market participants to accurately price ETFs. That the value of an active ETF’s underlying basket is published in real-time via ActiveShares should help assuage investors. “Seeing the value of the underlying basket via the Verified Intraday Indicative Value will give market makers some level of comfort on where they should quote the ETF since they will not know the underlying basket,” says one report. 7 The key argument made by advocates of non-transparent ETFs is that, once a mechanism is in place to allow participants to price funds accurately, the portfolio disclosure processes of such funds will be similar to those at actively managed mutual funds – which typically only publish information about all of their holdings semi-annually in their financial statements.
Non-transparent ETFs provide ample advantages to end investors, enabling them to diversify their exposures beyond passive index trackers.
Right now, there are 6,736 ETFs globally8, of which 300 are actively managed. 9 Historically, active managers eschewed ETFs out of fear that the daily disclosure obligations made them vulnerable to copycat traders, predatory hedge fund short squeezes or even front-running. This is not an issue at non-transparent ETFs as their portfolio disclosures are not performed on a daily basis.10 Non-transparent ETFs could also help active managers target a much wider investor audience through new marketing and distribution channels such as robo-advisory platforms. Furthermore, if their strategy is successful and resonates with investors, there is an opportunity to accumulate greater assets and, as a result, offer more competitive fees than actively managed mutual funds. There is certainly a growing momentum behind this new product. So far, nine major fund management groups including BlackRock, Capital Group and JP Morgan Asset Management have signed up to license ActiveShares as they look to launch non-transparent ETFs.11
Non-transparent ETFs provide ample advantages to end investors, enabling them to diversify their exposures beyond passive index trackers. Elsewhere, US investors are likely to enjoy significant tax advantages,12 insofar as their returns will not be subject to capital gains.13 Investors will also not be unduly impacted by the performance drag that arises when active managers are forced to hold surplus cash to satisfy redemption requests.14 From a regulatory perspective, there has been some investigation into whether the success of passive ETFs could lead to price distortions across wider markets. To date, there has been no evidence of this occurring although the approval of non-transparent ETF products will result in greater numbers of investors acquiring exposure to a more diverse set of ETFs.
Will non-transparent ETFs be allowed in Europe?
While the SEC has given its tacit backing to the concept of non-transparent ETFs, the wrapper is yet to receive an endorsement from European regulators, most notably Luxembourg’s CSSF and the Central Bank of Ireland (CBI), the two leading fund domiciles inside the EU. Last year, the CBI said it saw no reason to amend existing ETF disclosure practices, although the SEC’s decision could prompt the Irish regulator to rethink its position and permit non-transparent ETFs to be distributed under the current UCITS framework. 15 The industry’s case for allowing such products to flourish inside Europe is a compelling one.
Given that retail-orientated UCITS funds currently disclose information about their holdings on a semi-annual basis, some experts query why non-transparent ETFs – which will also be regulated under the UCITS regime – should be held to a different standard or benchmark to actively managed mutual funds. 16 Others point out that the majority of long-term retail investors simply do not monitor their ETF portfolio holdings on a daily basis, and would be perfectly content with a less frequent reporting arrangement. 17 Should EU regulators authorise the roll-out of non-transparent ETFs, it could be a game changer for both asset managers and investors.
1 Financial Times (January 17, 2019) US active funds suffer record USD143 billion exodus in December
2 Moody’s Investors Service (March 14, 2019) Moody’s: Adoption of passive investment on track to overtake active in two years
3 Bloomberg (December 31, 2018) Shift from active to passive approaches tipping point in 2019
4 Financial Times (July 29, 2019) US passive-active fund split to reach parity by 2025
5 Financial Times (April 19, 2019) Non transparent ETFs set to be a boon for fund managers
6 Legg Mason (April 8, 2019) Precidian comments on US SEC approval of ActiveShares
7 Franklin Templeton (April 17, 2019) ETF Capital markets desk: Non transparent active ETFs – Coming soon?
8 www.ETFGI.com 30 June 2019 global ETF statistics.
9 Investment News (April 12, 2019) Who benefits the most from non-transparent ETFs?
10 Financial Times (April 19, 2019) Non transparent ETFs set to be a boon for fund managers
11 Financial Times (April 19, 2019) Non transparent ETFs set to be a boon for fund managers
12 Barron’s (April 12, 2019) A new kind of actively managed ETFs can keep their portfolios hidden: Is that a good thing?
13 Investment News (April 12, 2019) Who benefits the most from non-transparent ETFs?
14 Investment News (April 12, 2019) Who benefits the most from non-transparent ETFs?
15 ETF Stream (April 29, 2019) Seeking European clarity on non-transparent ETFs
16 ETF Stream (April 29, 2019) Seeking European clarity on non-transparent ETFs
17 ETF Stream (April 24, 2019) Central Bank of Ireland should follow SEC in allowing non-transparent ETFs