Precidian Investments, a fund industry intellectual property firm that’s also behind the Maxis Nikkei 225 ETF (NKY), filed regulatory paperwork to gain permission to market nontransparent, actively managed ETFs that’s almost identical to paperwork iShares’ parent BlackRock Inc. filed in the summer of 2011 .
Unlike already-live transparent active ETFs, like Bill Gross’ now-$4 billion Pimco Total Return ETF (BOND), Precidian’s “exemptive relief” petition to the SEC is asking to market ETFs that have periodic portfolio disclosures, such as those the commission requires for mutual funds. It’s also quite unlike plans for nontransparent ETFs the mutual fund company Eaton Vance has in the works.
At the center of Precidian’s and BlackRock’s plans is a blind trust working on behalf of the authorized participant (AP) that would keep disclosure of portfolio holdings under wraps until regulators require it. Existing mutual funds must disclose holdings every three months with a lag, and it appears BlackRock’s plan, if approved by the SEC, would include disclosure requirements similar to those in place for mutual funds.
“While the funds are nontransparent ETFs, Applicants do not believe that the Funds raise any significant new regulatory issues or that the lack of disclosure regarding a Fund’s portfolio holdings on daily basis will in any way make the fund more susceptible to manipulation for the benefit of one group over another,” the filing said in a turn of phrase that was identical to one found in the BlackRock petition in 2011.
However, while the Precidian and BlackRock petitions for relief are clearly quite similar, they aren’t entirely alike. It appears, for example, that a special arbitrage window aimed at keeping the price of such nontransparent active ETFs in line with their net asset values that would open on select occasions would be more or less open all the time in the version contemplated by Precidian.
Day to day, APs for the products would effectively be doing creations and redemptions for cash and hedging the funds based on the fact that they could redeem shares for the exact cash value of the funds’ net asset value (NAV). Creations and redemptions would happen in kind in the blind trust, allowing the fund to enjoy some of the tax efficiencies that transparent ETFs currently enjoy.
Crucially, the blind trust would be able to do what APs at the center of any index-based ETF are able to do as well, such as eliminating higher-cost securities to get rid of imbedded capital gains at the fund level. Such cherry-picking of securities is a key reason ETFs are considered to be more tax efficient than mutual funds.
The Precidian and BlackRock concept goes to the heart of an ongoing pursuit in the money management industry to provide strategies that aim to beat market benchmarks. A big part of that pursuit is a belief among managers that keeping portfolios secret gives them an edge over others in the market.
Without that, they say, anybody can quickly steal their “secret sauce” and undermine their edge.
Officials at New Jersey-based Precidian declined to comment on the filing, a customary response when it comes to conforming to regulatory quiet periods.
Transparent Active Funds
Precidian’s and BlackRock’s plans amount to radical departures from actively managed strategies to date.
As it stands, the SEC requires daily disclosure of portfolio holdings of active ETFs, and most indexed ETFs choose to disclose their full holdings daily.
Companies like Pimco and WisdomTree have had some success gathering assets in such actively managed strategies that disclose holdings daily.
The most successful funds thus far are in the fixed-income space, such as Pimco’s BOND, and the Pimco Enhanced Short Maturity Strategy (MINT), which has $2.6 billion, according to data compiled by IndexUniverse. Additionally, the WisdomTree Tree Emerging Markets Local Debt Fund (ELD) has gathered more than $1.76 billion.
As things stand, less than 1 percent of the $1.425 trillion in total U.S.-listed ETF assets is invested in active strategies.
A Nontransparent ETF Future?
Boston-based Eaton Vance, as noted, has said it’s planning to market nontransparent ETFs using patents it obtained when it acquired Managed ETFs, a company owned by longtime ETF industry consultant Gary Gastineau.
The Eaton Vance plan centers on the use of trading based on a fund’s end-of-day NAV.
NAV-based trading allows managers of nontransparent funds to trade securities throughout the day at prices determined at or relative to NAV values calculated on that day.
It’s an idea that makes some advisors wonder whether the trading efficiency of ETFs might be compromised if intraday purchases and sales wouldn’t be definitively priced until the end of the session.
A Different Ball Of Wax
The disclosure requirements described in the Precidian and BlackRock filings seem to be much closer to currently prevalent disclosure requirements for mutual funds.
That’s significant because a number of industry sources say that the many mutual fund companies that have made tentative steps to begin offering exchange-traded funds might leap head-first into the ETF business if they could keep their portfolio disclosures to a minimum, as they do now.
Mutual fund companies are also said to be loath to transition assets from existing funds into cheaper funds. Moreover, much of the mutual fund industry’s success is predicated on a well-oiled distribution machine.
That means that assets segueing into ETFs—where distribution infrastructure is relatively undeveloped—would mean the mutual fund industry would lose contact with many of its end investors.
More Mechanics Of Nontransparent ETFs
Regarding creations in the proposed structure, the Precidian filing—again with the exact same language as the BlackRock filing—said:
“Since Creation Units will be created solely by the deposit of cash and will typically be redeemed by distributing securities of the fund’s portfolio to a blind trust that will liquidate the portfolio securities in accordance with instructions from the authorized participant redeeming shares, neither the adviser nor the fund sub adviser will be able to cause an authorized participant to engage in transactions in which the funds could not engage directly or to otherwise use the in-kind process to circumvent applicable restrictions under the Act.”
Also, when ETF shares are liquidated, the AP would receive cash—again, never knowing what made up the ETF shares that the blind trust redeems.
Crucially, the blind trust becomes a part of the creation and redemption mechanism that is at the center of how an ETF functions. Because that doesn’t change, that means tax inefficiencies and cash drag that are the Achilles’ heels of many mutual funds are likely to be neutralized under the proposed structure.
When faced with redemptions, the fund would have two choices of response:It could raise cash at the fund level if it has a loss it wants to lock in for tax reasons, or it could hand out shares in-kind to the blind trust that would then liquidate shares on behalf of the AP.
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