As exchange-traded funds (ETFs) have grown in popularity with investors, many managers and fund sponsors have looked at the structure for funds beyond passive index trackers. The number of traditional active ETFs have soared in return years and many ETF pundits expect the number to increase exponentially as investors take advantage of the benefits of the fund structure.
But not all traditionally active ETFs are the same.
Thanks to new SEC rules governing traditional active ETFs, these funds can now come in a variety of flavors. For investors, differences in how they are structured can make a real impact on investing decisions and how portfolios can meet financial goals.
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As a whole, most ETFs are built using rules under the Investment Company Act of 1940, meaning they are structured very similarly to mutual funds. The SEC has granted ETFs a few exceptions under the rules, which allow them to function in the way we both know and love. This includes the ability to only sell shares to large authorized participants (APs) rather than directly to investors. Another big difference and exception comes down to disclosure.
Because of their daily trading ability and market-maker requirements, ETFs were required to list their holdings daily. APs need to know what they are buying when they create/redeem shares. Mutual funds, on the other hand, are only required to list their holdings quarterly. For the first round of ETFs, this wasn’t a big deal. Afterall, if you’re tracking the S&P 500 Index, everyone knows you’re holding Apple stock.
The problem comes when active managers want to use ETFs as their fund’s structure.
Because of this transparency, anyone could see what was in an active ETF every single day. Many managers complained that this could lead to so-called “front-running” of the funds. For example, you could see what a guru like Cathie Woods was buying or selling. If her ARK Innovation ETF (ARKK) suddenly added a small-cap biotech stock, you could go out and buy shares. For some mega-gurus and top managers, this limited their ability to get good deals on firms or build full positions as investors quickly copied them.
Another issue is that investors could literally build active ETFs on their own. If you like Wood’s ideas, you could see what was in the fund and buy those stocks on your own, thereby avoiding paying the fund’s expense ratio. And given that most brokers charge $0 commissions now, this could be a very cost-effective way to get exposure.
As fund managers complained, the SEC has potentially listened. The regulatory agency has started to approve several semi-transparent structures and rulings for active ETFs that provide relief of the Investment Company Act of 1940. This would allow fund disclosures on a quarterly or semi-annual basis, potentially eliminating the front-running issue.
And they take very different paths to do so.
For example, the Precidian ActiveShares model uses authorized participant representatives (APRs). These groups act like a middleman for the authorized participant in the fund. So, the AP buys shares from the APR, who in turn buys shares from the fund. In this transaction, only the APR and fund manager would know what is actually in the ETFs holdings. Precidian isn’t alone; Blue Tractor, the New York Stock Exchange, Fidelity, T. Rowe Price and Natixis Investment all have different ways of doing this. Several have licensed their structures to other managers in order to bring semi- and non-transparent ETFs to the market quickly.
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For investors, the birth of semi- and non-transparent ETFs could be a double-edged sword. On the one hand, the lack of disclosure could lead to better returns. After all, if people don’t know what their ETF holds, they can’t buy shares and drive up prices before the fund manager has a chance to develop a position. Keeping a manager’s secret sauce hidden could be very beneficial indeed.
But there are some concerns as well.
For one thing, some of the semi-transparent structures use so-called proxy creation/redemption baskets. These differ slightly from the fund’s holdings and can include derivatives to mimic the basket’s value, decoy securities and even alternative weighting schemes. This could hinder the APs ability to fairly value the basket, cause wide bid-ask spreads on the secondary market and have ETFs whose prices wildly differ from their net asset values (NAVs).
Another concern could be taxes. APs can either hand back cash or the securities that make up an index to a fund sponsor to create ETF shares. But some pundits have postulated that ETF managers will have to buy and sell securities received in these proxy creation/redemption baskets to get the assets they really want. This will show in capital gains distributions to investors. While minimal so far, several active ETFs have started to pay gains distributions to investors, eliminating one of the main benefits of ETFs and their tax efficiency.
Finally, semi- and non-transparent ETFs cost more than their index-tracking rivals. One of the main hurdles for mutual funds and being able to “beat the market” has been their high fees. Semi-transparent ETFs may not be able to overcome fees enough to justify them from investors.
Active ETFs represent another tool to meet their financial goals. As for choosing a traditional active ETF or one of the newer semi-transparent ETFs, the decision comes down to how comfortable you are with perhaps not knowing what’s in your fund. Mutual funds are at least priced each day based on their holdings even if we only see that once every three months.
Depending on what structure the active ETF chooses, we may or may not be getting a fair deal when we pick up shares. That’s something to seriously consider when selecting one of these funds.
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