Non-transparent ETFs: Potentially a new wave of active products

July 17, 2019

A blog post by Kedar Anant Pandit, senior analyst at the Deloitte Center for Financial Services, Deloitte LLP

April 2019 marked an inflection point in the investment management industry when passive domestic equity funds reached their active counterparts in terms of assets under management.¹ Investors have been attracted to passive products because of lower costs, better tax efficiencies, as well as the greater transparency offered through a widely used passive structure, exchange traded funds (ETFs). The latest change is the addition of truly actively managed equity ETF products.

Many active managers have sought Securities and Exchange Commissions (SEC) approval for novel exchange-traded structures that provide investors with some of the same benefits, while also protecting the managers’ intellectual property in terms of portfolio holdings and trades. These “next-generation” structures may enable active funds to lower costs and increase tax efficiency while maintaining control over transparency.

Recent history

These innovations began in February 2016 when Eaton Vance launched NextShares funds, which seeks to lower costs more than traditional mutual funds and exhibit tax efficiency similar to that of an ETF without the need for daily portfolio disclosures.² The next major development came in the form of the SEC approving Precidian Investments’ ActiveShares ETF model in May of 2019.³ The ActiveShares structure allows the portfolio to be disclosed only to “Authorized Participant Representatives,” a new intermediary in the value chain that sits between the fund managers and the authorized participants. This new role conducts all the buying and selling of shares confidentially and independently of Authorized Participants to protect the intellectual property of the investment manager.

The SEC is currently reviewing several other non-transparent ETF model applications from Eaton Vance (Clearhedge), T. Rowe Price, and NYSE/Natixis Advisors. If approved, active managers may have choices of next-generation ETF structures to shield their intellectual property. Exemption from daily portfolio disclosures may address some active managers’ concerns about investors free-riding and competitors reverse engineering their investment strategy.

Can a lower cost active product structure change the game?

Prior to these recent developments in non-transparent ETFs, there were few active equity ETF products. Total actively managed ETFs accounted for 13 percent of ETF products in 2018, comprising just 2 percent of total ETF assets.⁴  Fixed income products dominate the active ETFs space and constitute more than three-fourths of the actively managed assets today.⁵ Investment managers have been comfortable launching active fixed income products because they are not easily replicable or prone to free-riding, unlike active equity ETFs. However, the non-transparent ETF structures could prompt new active equity ETF product launches over the next 12 months. The novel ETF structures would make a full spectrum of product strategies available to investors ranging from pure passive to fully active.

The next generation structures will take active investing to the next level, as firms will be able to offer a broad range of active strategies through ETFs, provide an alternative to traditional mutual funds, and possibly lead to net inflows into active investing.

It remains to be seen how investors receive the next generation of ETFs. In some instances, mutual funds are unlikely to be displaced. Long-term retirement portfolios such as 401(k) plans are one such example. The degree of success of next generation ETFs depends on how investment managers are able to distribute these products while keeping the costs low. Compared to an index ETF, investors are likely to need more education and guidance on the unique portfolio characteristics and risk profile of each new active ETF. Also, investors may buy non-transparent ETFs for the strategy rather than a specific basket of securities. Advisors will likely play a greater role in terms of explaining the product strategy to investors. Their role may be crucial to make investors aware about how active ETFs suit their needs. Unlike passive ETFs, investors are less likely to select active products without advice and guidance.

New development levels the playing field

Fees and distribution access are both strong drivers of asset growth, along with the promise of alpha and portfolio risk and return characteristics. Passive ETFs have had a strong multi-year run gathering assets, but this active ETF development may turn the tide in favor of active funds. Also, a significant market correction in the future may boost demand for the risk and performance characteristics of actively managed portfolios. Retail and institutional investors alike may seek the characteristics that actively managed ETFs can provide.