By Frank Koudelka, Global ETF Product Specialist at State Street.
Frank Koudelka, Global ETF Product Specialist at State Street.
The highly anticipated regulatory approval of a new class of semi-transparent active ETFs has captured the imagination of the market — prompting investors to think of ETFs in a whole new way.
Following the Securities and Exchange Commission’s (SEC) final approval for Precidian Investments’ ActiveShares structure on May 20, actively managed ETFs do not require the sponsor to publish daily portfolio holdings to the market, yet still trade like a traditional ETF.
This new development opens the door to a range of active managers who previously were not comfortable disclosing their best ideas to the wider market. It also gives managers assurance that they can protect their proprietary intellectual property while still taking advantage of the many benefits of an ETF structure.
While there has been plenty of activity in the active fixed income ETF space, it is expected that the Precidian approval will accelerate innovation in active equity ETFs, as industry participants now have favorable regulatory guidance to proceed.
The initial approval for semi-transparent active shares comes at an especially poignant time in the market. Active mutual funds have seen declining market share and face heightened expectations from investors demanding better fees and liquidity. Investors have been drawn to ETFs for their liquidity, ease of trading and cost-efficiency.
But after a decade of rapid growth and significant market concentration amongst the largest providers, many in the industry have started to question what opportunities are left for new market entrants and new products. It is now expected that the Precidian approval will usher in more opportunities for other players to enter the market with innovative ideas for ETF products.
Several important differences are evident between traditional and semi-transparent ETF structures. With traditional ETFs, only an authorized participant (AP) has control of the trading process. The semi-transparent active structure introduces the new role of AP representative, who is independent of the AP and the fund.
The AP representative will use confidential accounts to compile the inventory necessary to complete the in-kind delivery to the fund, thereby shielding the information from the broader market. In terms of required holdings disclosure, non-transparent active shares will follow the quarterly reporting practice of open-end mutual funds.
Another significant difference is how portfolio valuation works. The majority of traditional ETFs disclose portfolio holdings daily, publishing an intraday indicative value (IIV) every 15 seconds. Semi-transparent active shares will increase this frequency and add a verification process, publishing a verified IIV every second of the trading day on the consolidated tape, which is confirmed by the calculation agent to minimize discrepancies.
Managers considering if semi-transparent active ETFs are right for their business should also note that active share ETFs can only be composed of US exchange-listed securities. For managers that specialize in the foreign market, this model is not viable in its current structure.
As the industry continues to evolve, the effect on distributors and broker/dealers handling of similar products remains to be seen. In the US, managers will almost certainly experience an acceleration of the longstanding struggle for limited shelf space. If the underlying investment approaches are identical, lower-cost products are likely to win over their more expensive counterparts.
In light of this, managers will have to think very carefully about how a new ETF would work within the context of their wider product offering. They can’t simply clone an investment product that didn’t work well in a mutual fund structure and expect that it will work as an ETF. Instead, they should look to articulate how the product will deliver unique value and make sure that message resonates with advisors and investors.
The future is bright for active equity ETFs. So much is happening across the industry right now — zero-fee ETFs, smart beta, and plenty of interest in thematic strategies, as funds focus more on alternatives and economic, social and governance issues. The regulatory approval of ActiveShares will help breathe new life and new ideas into what is already an exciting part of the market.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)