Non-transparent & Semi-transparent ETFs

Active ETFs have been slow to take hold, and most observers believe it is because of the daily transparency in ETFs, exposing a portfolio manager’s decision making and intellectual property.

There has been a meteoric rise in ETFs over the past decade plus, but the overwhelming majority of those ETF assets are in passively managed index ETFs, funds that track a market or industry index with a fixed portfolio.

ETFs publish their portfolio composition file every night, which means anyone with access to the internet can see exactly what a portfolio manager in an ETF has done the previous trading day.

Many portfolio managers balk at the idea of laying bare their investment decision-making to the public, feeling that full transparency diminishes the value of the intellectual property the portfolio manager’s investment selection methodology brings to the table.

To deal with this issue, several firms made filings with the SEC to offer portfolio disclosure alternatives, with varying degrees of portfolio non-transparency. Five of these non-transparent ETF or semi-transparent ETF structures were approved in 2019. At least two more structures are in registration.

Industry sentiment seems to believe that actively managed ETFs are now able to thrive since there is now some protection for the portfolio management process.

Precidian was the first to receive SEC approval, and is the most opaque of the new structures, posting portfolio information only quarterly, following the same process as open end mutual funds.  The other four structures were all approved in December 2019. T Rowe Price and Fidelity have proprietary models for their firms’ internal use.

Nottingham has entered into agreements with the New York Stock Exchange AMS structure and with the Blue Tractor Shielded Alpha structure.

These choices were made based on industry conversations and feedback. The market makers for the ETF are a critical component. The market maker must have a market value of the ETF on a current basis in order to make a bid-ask spread to ETF shareholders to purchase or sell their shares.

Precidian does not disclose the actual portfolio to any party other than a designated firm that is given the full portfolio information and the licensed authority to transact on that ETF’s basket of securities for shareholder settlement. This method is the least transparent of the proposed solutions and requires a new method of ETF basket execution.

Blue Tractor includes all the portfolio securities in the ETF’s creation basket, used both for shareholder transactions and for market making, however under their structure a security’s % weightings in the creation basket will always differ from its correct % weighting in the actual ETF portfolio.  This basket structure effectively hides a fund manager’s portfolio and trading strategy, but still provides authorized participants (APs) and market makers with the transparency they require to conduct efficient trading under all market conditions.

The NYSE AMS model allows for the public disclosure to be partially incomplete, using proxy securities. As an example, the actual portfolio might contain ExxonMobil, but the disclosed basket might substitute British Petroleum. The securities are not identical, and the public will not know which security is actually in the portfolio, but the historical correlation between the two similar securities poses a manageable tracking risk for market makers and APs transacting with the ETF.

It remains to be seen whether the non-transparent ETF models will attract active portfolio managers, many of whom have been very successful in managing open-end traditional mutual funds, into the ETF world.  Thus far the Precidian model is the first to come to market.

Nottingham’s affiliates Spinnaker ETF Series and advisor OBP Capital appear to be the first white label issuers to file the short form applications with the SEC to adopt both the Blue Tractor and NYSE AMS models.