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A New Day For Active ETFs

ETF letter blocks on piles of coins.
photo by Marco Verch, licensed under Creative Commons

The U.S. Securities and Exchange Commission greenlighted a change to actively managed exchange-traded funds earlier this year. You may have missed it at the time, but this decision could have a major impact on how we invest and trade.

Active ETFs are a type of hybrid security. Like actively managed mutual funds, their investment returns depend on the skill of a manager who is trying to outperform a particular benchmark index, rather than simply mimic it. Like traditional ETFs, however, active ETFs trade on exchanges throughout the day. This gives investors access to intraday trading and real-time pricing.

Until now, most successful ETFs have passively tracked an underlying index. Active ETFs have remained a much smaller part of the financial landscape. The Mutual Fund Observer recently noted that fewer than 300 active ETFs have gotten off the ground. These funds represent only about $80 billion in investment across the $4 trillion ETF industry. Investors and advisers alike have stayed away for one major reason: the transparency requirement.

Until now, active ETFs have had to report complete portfolio holdings daily. Yet active managers often need more than one day to build a new position in a given stock. In a mutual fund, which typically reports holdings on a quarterly basis, this is not a problem. But in an active ETF, daily reports could tip a manager’s hand and distort the price of a stock before the manager has finished building the desired position.

The SEC may have fixed this problem. In a filing, the regulatory body said it would approve Precidian Investments’ proposal for a nontransparent ETF. This new category of fund would not need to disclose all of its holdings to every investor. Instead, the SEC said that the ETF could disclose the fund’s portfolio details to a handful of key players. These individuals, known as “authorized participation representatives,” would ensure that the price of the ETF remained in line with its underlying assets while keeping the manager’s moves confidential. The funds would reveal their positions to all investors quarterly, as most mutual funds do.

New Jersey-based Precidian has worked on securing the SEC’s approval for a nontransparent ETF structure since 2014, amending the proposal multiple times to respond to the commission’s various concerns. The SEC approved Precidian’s design for a nontransparent ETF in May. Precidian’s “ActiveShares” ETFs are now legally cleared to proceed. The SEC is also considering other similar requests for nontransparent ETFs, though it is unclear when it will make those rulings.

The SEC’s decision is still recent, so it is possible that the creation of nontransparent active ETFs could create new problems that are not yet clear. On the other hand, it may do the trick to finally make active ETFs a winning proposition for managers. If so, the market could see an influx of new active ETF products. The Wall Street Journal reported in mid-July that firms including JPMorgan Chase & Co., Capital Group Cos. and Legg Mason Inc. plan to launch nontransparent active ETFs as soon as the end of 2019. Precidian licenses its technology, including the ActiveShares framework, to other organizations for a recurring fee. Precidian’s licensees include BlackRock, Nuveen and Nationwide, according to Stuart Thomas, a principal at the firm.

If they work, nontransparent active ETFs could offer certain advantages over actively managed mutual funds. ETFs are generally cheaper for investors. They also offer tax advantages; unlike mutual funds, ETFs rarely expose shareholders to significant year-end capital gain distributions. Managers are also likely to find these new active ETFs attractive, as they combine limited transparency requirements with the ability to easily sell shares to the public on stock exchanges. This sets ETFs apart from mutual funds, where shares are bought and sold only through brokerage accounts and platforms that have negotiated distribution agreements. For example, investors cannot buy Vanguard mutual funds at Morgan Stanley, a huge U.S. brokerage firm. But they can buy Vanguard’s ETFs, just as they would any other U.S. stock traded on public stock exchanges.

Like other actively managed investment products, active ETFs will cost more than their passive counterparts. But with the requirement for daily transparency removed, it is possible that those increased costs may be worthwhile, especially for inefficient asset classes where active managers have demonstrated the ability to outperform their benchmark over the long term.

While I have been skeptical of active ETFs in the past, if this new model works, they could become the future of active fund investing, replacing the open-end mutual fund model that has existed for almost 100 years. Active ETFs alone are unlikely to stem the rising tide of index funds. But the SEC has done its part to set the stage for active ETFs to grow by leaps and bounds.

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