Navigating Active Non-Transparent ETFs

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Active nontransparent ETFs (ANTS) have frequently been in the news lately, and many wealth managers have asked, “How does this affect my practice and my clients?”

Some background on what ANTS are, and why they have become a new addition to the investment fund marketplace will be helpful to consider the impact on a wealth manager’s practice.

Over the last decade, ETFs have become an ever-larger portion of the investment fund universe. Passive ETFs provide low-cost, tax-efficient, diversified access to sectors, geographical regions, and key asset classes. Where the open-end mutual fund industry is split between passive index funds and actively managed funds, are more than 90% of ETFs track passively managed indices, with very little market penetration for actively managed ETFs.

The reason is structural. A key component of ETFs is transparency, since to trade on the securities markets like an equity, the market makers must know what comprises the ETF portfolio and price those underlying securities throughout the trading day. ETFs publish their portfolio composition files every night, and those portfolios are available to the investing public so that the potential investor will know what the ETF holds.

This concept is great for transparency but not for the portfolio manager expending time and effort on research, analytics, and using personal wisdom and experience to make portfolio selection decisions. If the results of that time and effort are fully available to the public to see and mimic each night, the investor might think, “I can just look at the portfolio and save the investment advisory expense.” Once the portfolio manager realizes this the natural reaction is usually, “I’m making all this effort for nothing, because I won’t get paid for my intellectual property.”

ANTS and semi-transparent structures are designed to deal with this very issue. There are several structures that have been proposed and have been authorized for license by the SEC for use in ETFs. Each of the opaque structures avoids disclosing the actual ETF portfolio. The most non-transparent structure does not publish its portfolio daily at all, instead adopting the open-end mutual fund reporting timeline of publishing its portfolio semi-annually. The most transparent of the structures publishes most of the actual holdings within its ETF but alters the asset allocation and percentages of holdings to conceal some of the portfolio decision-making.

Other structures are in between these two extremes. To mask the specific portfolio selection, proxy securities might be used. For instance, the portfolio might be building or liquidating a position in General Motors and does not want to let this be fully known, so a substitute position of Ford might be included in the nightly portfolio disclosures.

A wealth advisor might ask, “Why are these ANTS important to my practice and for my clients?” The best answers are “differentiation” and “access.”

In a world where index and passive ETFs have become an ever larger portion of many individual’s investment programs, the last thing that a wealth manager wants to hear from a client is, “I’m not sure why I need to pay you a management fee when I’m primarily invested in index ETFs.” But with the economic status quo turned on its ear, actively managed portfolios are a wise diversification. Who would have expected such a potential change in the demand for commercial office space just one year ago? Many companies are offering work-at-home solutions as a long-term option. What will happen to the demand for office space? What about companies that service offices? How will the demand for more personal telecommunications and online security devices and services change? Many companies that will be affected by the changes in how the world economy operates are in various market indices. This begs the question, “Can passive index funds continue to be expected to provide a steady return and beat active strategies?”

An active portfolio manager can see what might be over the horizon and react quickly to how a paradigm shift affects various investment securities and investment classes positively and negatively. Offering active investment strategies is an important differentiator for the wealth manager.

ANTS provide access to those active managers, which was not available in ETFs. Many active managers have avoided ETFs due to the transparency.

One issue for consideration by wealth managers is transaction fees. Many platforms popular with investment advisors charge transaction fees for mutual fund purchases and redemptions, while ETFs are traded with no transaction fees by many broker dealers and platforms popular with advisors.

Younger investors prefer the instant access of mobile devices, stock and ETF quotes at their fingertips, and the flexibility of trading during the day rather than waiting for end-of-day pricing as is required of open-end funds.

One of the last vestiges of open-end mutual fund dominance is in defined-contribution retirement plans, especially among 401(k) administrators. At some point, the retirement industry will shift to a broker-custodied model, making ETFs an easier investment option for 401(k) participants. When this floodgate opens, the savvy wealth advisor will need to have differentiating options to compete, and the active strategies made available by ANTS will be among the key differentiators.

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