In 2019 the Securities and Exchange Commission approved a new type of actively managed exchange traded fund (ETF) interchangeably termed semi-transparent or non-transparent. The key benefit of these ETF structures (also commonly referred to as an ‘ETF wrapper’) for an active portfolio manager is that they protect a fund’s confidential portfolio strategy and associated portfolio trading, thereby preventing front running and free riding.
Six firms have developed various twists on the new ETF structure – Precidian, the New York Stock Exchange, Fidelity, T. Rowe Price, Invesco and Blue Tractor Group – and the intellectual property associated with each of these wrappers is currently being licensed to fund managers seeking to bring proprietary active strategies out of the traditional mutual fund and SMA world and into an actively managed ETF.
These ETF wrappers all differ from fully transparent active ETFs because they are not mandated by the SEC to disclose (through a daily published portfolio composition file, or ‘PCF’) the exact contents of the underlying portfolio. Instead, these ETFs are required only to disclose their actual portfolio contents on a quarterly basis, so essentially mimicking the portfolio transparency of an actively managed mutual fund, while still reaping the benefits of a fully transparent ETF structure for investors versus a mutual fund wrapper; including lower cost, tax efficiency and instant liquidity.
However, the SEC does require that these new wrappers disclose on a daily basis additional information and metrics to the ETF capital markets to ensure orderly primary and secondary market pricing, trading, liquidity and effective arbitrage. In the case of the NYSE, Fidelity, T. Rowe Price and Invesco, these ETF wrappers publish a proxy portfolio PCF employing substitute securities that mimic (or proxy) the actual portfolio securities. Precidian’s ETF wrapper doesn’t publish a PCF; instead, the actual portfolio is provided to a special purpose capital markets participant (known as the authorized participant representative, or ‘AP-R’) who transacts as a middleman between the ETF fund and the capital markets. Blue Tractor is wholly differentiated because actively managed funds using this wrapper publish a daily PCF that does not employ proxy securities and moreover, an AP-R is not a necessary requirement.
The multi-trillion-dollar U.S. ETF market is skewed towards full portfolio transparency at this juncture. A key driver of this dynamic is that the majority of ETFs are passive vehicles that track an underlying, published index (think SPY, QQQ etc.) so there isn’t a requirement to mask the ETF portfolio and associated trading. Moreover, the highly successful actively managed ETFs managed by Cathie Wood at ARK Investments are also fully transparent, as have many recent thematic ETF launches from firms such as Global-X.
However, many active portfolio managers currently using the mutual fund wrapper are not comfortable with complete daily portfolio transparency and are therefore interested in the semi-transparent ETF structure. Tailwinds expected to drive this growth are actively managed mutual fund to ETF conversions and the desire for active ETFs versus traditional mutual funds by millennial and Gen-Z investors.
To date 41 actively managed semi-transparent ETFs have been launched, with over $2.1 billion of AUM, and industry observers expect many additional launches heading into 2022 and beyond. In contrast, the active mutual fund market (equity and debt) sits at around $10 trillion, so there is a lot of room for growth, as evidenced by the growing pipeline of active fund managers who have announced their intention to issue strategies inside the semi-transparent ETF wrapper. Expect to see more product, offering investment advisors more choice of novel and differentiated actively managed strategies for investors.
What are the key benefits of these wrappers for a registered investment advisor and their clients? First, semi-transparent ETFs open up a new avenue of exchange-traded investing, tapping into proprietary active strategies that until now were available only in mutual funds, SMAs and other wrapper structure. Second, investors benefit from lower costs for these products; as a rule, these ETFs are always priced lower than the comparable mutual fund strategy (so important for Reg BI and other fiduciary considerations). Third, because they are an ETF, investors can transact through their regular brokerage account and get immediate liquidity since they are exchange traded.
And four, these are highly tax efficient structures versus traditional mutual funds thanks to an ETF feature known as custom baskets. Most actively managed fully transparent ETFs utilize the custom basket feature to eliminate capital gains at the fund level, thereby preserving the fund’s investment returns and negating the requirement to distribute accrued capital gains to clients. However, its important to be aware that not all of the semi-transparent wrappers have SEC custom basket relief, potentially limiting their ability to be very tax efficient. Note that the Blue Tractor wrapper does have SEC custom basket relief, so funds using this wrapper are as tax efficient as they would be using a fully transparent ETF wrapper.
So how does one determine if a newly launched actively managed ETF is semi-transparent? Simply review the ETF’s fact sheet and SAI; semi-transparent ETFs have clear, plain English risk disclosure language.
And note too that currently the SEC limits portfolio managers using the semi-transparent ETF wrapper to primarily domestic exchange listed equity securities and futures. These ETFs are precluded from investing in fixed income securities, securities from Europe, Asia etc. and using any derivative instruments, including options. Many industry observers believe that portfolio manager use of semi-transparent ETFs will gain further momentum once these investment universe limits are lifted by the SEC.
All the recently launched semi-transparent ETFs are available on the main clearing platforms; Schwab, Fidelity and Pershing and some RIAs and independent broker dealer are allowing their advisors to put clients into these products; but each RIA and broker dealer will still need to approve individual funds on a case-by-case basis dependent upon their firm’s diligence hurdles, comfort level with the fund strategy, track record etc. Keep in mind that currently wire house advisors cannot recommend semi-transparent ETFs to their clients; however, this is widely anticipated to change in the not-too-distant future as these large firms complete their due diligence on this new class of ETF wrapper.
Let’s conclude with a real-world example of a portfolio managers utilizing the Blue Tractor semi-transparent wrapper to launch a proprietary active strategy. In mid-February 2021 SS&C ALPS Advisors launched a concentrated, actively managed real estate investment trust strategy on the Nasdaq Exchange (ticker: REIT) that has returned 16% since inception. Trading spreads for REIT have been excellent – as low as a penny wide on some days – meaning that investors can buy and sell these funds at prices very close to their underlying net asset value, ensuring a consistent client experience. Learn more at https://www.alpsfunds.com/products/etf/REIT.
Realistically, at the end of the day investment advisors don’t really need to concern themselves with the structural details of all the semi-transparent wrappers. Advisors can rest assured they do what they claim to do, because the SEC has authorized them and the clearing platforms have approved the underlying structure and fund strategy. What ultimately matters of course for an investment advisor and their clients is the active fund manager’s performance and their ability to generate alpha.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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