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Transparency Vs. ‘Tyranny Of Benchmarks’

Lara Crigger

According to Don Schreiber Jr., passive ETFs are weapons of mass destruction.

"Passive [investing] is probably one of the most dangerous things I've seen in my 35-year career," said the founder, CEO and co-portfolio manager of the $1.8 billion WBI Investments.

That, in large part, stems from transparency. Knowing an ETF's full basket of securities gives investors a false sense of security, says Schreiber, and encourages herd mentality.

"[Passive] is a crowded, one-sided trade into products that ride the roller coaster up and down," he said. "It crushes people's ability to retire comfortably."

That's one reason why he and many other product issuers have jumped on the actively managed ETF bandwagon (WBI Shares now offers 12 active ETFs cumulatively worth $1 billion). Active ETFs promise all the tax efficiency and trading flexibility of an ETF, backed by the expertise and discretion of an active manager.

Just one problem: Most investors don't seem to want them.

‘Active Is Not Dead’

Today 191 actively managed ETFs are on the market, but they've struggled to gain significant market share. Together these funds have amassed $36.9 billion—barely one 1% of the $3 trillion ETF market.

That's not to say active ETFs haven't carved out a niche. Particularly in the fixed-income space, heavyweights like PIMCO's $7.1 billion Enhanced Short Maturity Active ETF (MINT) and the $3.4 billion SPDR DoubleLine Total Return Tactical ETF (TOTL) have attracted plenty of investors.

But with few exceptions, active ETFs have languished in the equity space and beyond.

Still, it's too early to discount active ETFs, cautions Bill Donahue, managing director of PricewaterhouseCooper's ETF practice. "I would not suggest active is dead."

Some money managers even prefer them.

 

"I've used passive ETFs for years, but I'm an even bigger fan of active ETFs," says Chris Bertelsen, president and CIO of $2 billion Aviance Capital. His firm has used, among others, the AdvisorShares Newfleet Multi-Sector Income ETF (MINC), the First Trust Senior Loan Fund (FTSL) and the First Trust North American Energy Infrastructure Fund (EMLP). "Active ETFs allow us more flexibility and targeting in what we want to do for our clients."

Passive indexing, he says, is "subject to the tyranny of benchmarks," meaning indexed funds must hold whatever is in their indexes and in exact weights, regardless of whether those holdings are a good or bad idea. In down markets, that means index investors will hitch their wagons to underperforming or volatile stocks.

"With active management, though, you can try to make the downdraft as small as possible," Bertelsen added.

Transparency: The Existential Question

Active ETFs face significant hurdles; however, the biggest isn't an investor objection, but an issuer one.

Under current SEC rules, all ETFs must publicly disclose their complete holdings daily. (In contrast, mutual funds are only required to disclose holdings once a quarter.) This vexes active managers, who worry about telegraphing their hand to front-runners or to those who'd steal their strategies.

Transparency, however, is the secret sauce that makes the ETF vehicle work.

ETFs rely on special market makers known as "authorized participants" (APs) to maintain liquidity. APs have the purchasing power to buy up all the securities in an ETF's index and exchange them with the ETF provider for a block of ETF shares known as a "creation unit." Likewise, APs can buy up a creation unit's worth of ETF shares and redeem them for the underlying shares.

APs don't do this out of charity, of course. By harnessing minute discrepancies between the cost of a creation unit and that of an ETF's underlying securities, they can make big-league money. This arbitrage process also just so happens to keep the price of an ETF's shares in line with the cost of its underlying securities, thereby ensuring the ETF is fairly valued. Everybody wins.

So it's vitally important that APs know, at all times, exactly which securities are in an ETF and in what amounts. Without this knowledge, they won't be able to spot arbitrage opportunities. ETF prices will spiral out of whack. The whole system falls apart.

 

"If [ETF] daily known holdings become less transparent, it's a problem for market makers to maintain an orderly market," noted Schreiber. "Spreads will widen, because market makers must take on more risk."

To be fair, not all ETF issuers are bothered by the SEC's disclosure requirements.

"I always wonder if it's a red herring," said Ryan Issakainen, senior VP and ETF strategist for First Trust. The firm offers 28 fully disclosed active ETFs totaling $9.3 billion in assets—roughly one-quarter of all active ETF assets. "Many [managers] say they can't do what they want in a transparent structure, but we disclose our holdings every day and still have managed to build robust funds."

Yet many of the biggest names in the mutual fund industry have dragged their feet on launching ETFs. That's why some companies have attempted to lure recalcitrant managers with hybrid products that alchemize nondisclosure with exchange-trading in the hopes of satisfying investors, issuers and regulators alike.

Arbitrage Via Middleman

By our count, Precidian Investments is the only company promising a truly nontransparent active ETF, though BlackRock, State Street and PowerShares have filed for their own versions based more or less on the same idea.

ActiveShares would solve the transparency issue by reporting fund holdings only when required to; namely, once a quarter, like mutual funds. 

To facilitate market-making, however, the structure would establish a confidential account between the AP and the ETF, managed by a middleman broker. (Formerly, this was called a "blind trust," but the company has since dropped that language after SEC objections.)

If an AP wants new ETF shares, she gives cash to her broker, who goes out and buys a secret list of securities on her behalf, then performs the in-kind exchange with the ETF company that currently APs do themselves. The AP would receive her shares at the end of the day, priced at the ETF's net asset value (NAV).

Redemption works similarly: The AP would give her ETF shares to her broker, who'd exchange them for the underlying securities, sell them on the open market, then give the AP cash.

 

No Reverse-Engineering

The system preserves the basic gist of the creation/redemption mechanism while concealing the fund's portfolio in a way Precidian says can't be reverse-engineered.

One problem: APs won't know exactly what's in the ETF when they place their order. They'll have to guess, so they can hedge their exposure between the time they order and the end of day, when creations and redemptions are processed.

Precidian plans to address this problem by publishing a "verified intraday indicative value" (VIIV) every second (versus every 15 seconds, as current intraday NAVs currently are). This VIIV would be available to everybody—APs, specialists and retail investors, giving everybody the best possible estimate of fair value all at once.

Precidian declined to go on record for this article, citing concerns it might impact its standing with the SEC. Precidian's filings have been in limbo with the regulatory agency for years.

But that hasn't stopped other firms from betting ActiveShares will soon be approved: J.P. Morgan, for example, announced in early 2017 it planned to license Precidian's model, while American Funds made a similar announcement in 2014. And Precidian has eight of its own ActiveShares ETFs in registration, to be subadvised by Legg Mason.

NAV-Based Trading Gains Steam

Even as Precidian has suffered years of delays, NextShares Solutions, a wholly owned subsidiary of Eaton Vance, has launched its own take on the active exchange-traded product.

Notably, NextShares aren't actually ETFs. They're active exchange-traded managed funds (ETMFs).

NextShares discloses its funds quarterly, like a mutual fund, but trade intraday, like an ETF. The price at which NextShares transactions settle is equal to the fund's next end-of-day NAV, in a system known as "NAV-based trading."

Essentially, when an investor buys or sells NextShares, her trading costs are locked in immediately, but the actual NAV isn't set until after the market closes.

 

Perfect Transparency

"Investors have perfect transparency into their trading costs, because those costs are expressed as pennies above or below the NAV of the fund, which is calculated once a day," said Stephen Clarke, president of NextShares Solutions.

Of course, if NAV is set once a day, rather than discovered intraday, there's no longer any motive—or even ability—for APs to arbitrage.

That's a feature, not a bug, notes Clarke.

"Because market makers use end-of-day NAV, they're not taking on intraday trading risk, so they don't have intraday hedging requirements as they would for an ETF," he explained. "It's simpler, there's less risk and it should result in better pricing for the customer."

Already, eight NextShares ETMFs have come to market, worth a combined $75.1 million. Fifteen firms have licensed the NextShares model, including ALPS, Hartford Funds and UBS Asset Management, which plans to begin offering NextShares on its brokerage platform in the fall.

Other Plans

Other firms have announced their own plans. Blue Tractor's "Shielded Alpha" model would hide the complete ETF portfolio but give APs a similar-enough list of securities to use for hedging and arbitrage. Fidelity, meanwhile, wants to offer an active closed-end fund that would disclose holdings monthly, but only allow redemptions once a week.

Regardless of what cream rises to the top, says PwC’s Donahue, "our expectation is that we'll have one or more of these models approved in the next 12 months."

The question then becomes whether investors will bite. That's no sure bet.

"Anything that lacks transparency makes me very nervous," says Aviance’s Bertelsen. "We would have to look very hard at these products before employing them. Very hard."

 

TIMELINE

March 25, 2008: Bear Stearns launches the Bear Stearns Current Yield Fund (YYY), the first actively managed ETF.

April 11, 2008: PowerShares launches the first actively managed equity ETFs.

Oct. 1, 2008: Bear Stearns shuts down YYY after declaring bankruptcy in the midst of the financial crisis. The ticker has since been reassigned to another fund.

Nov. 16, 2009: PIMCO launches the PIMCO Enhanced Short Maturity Active ETF (MINT), currently the largest actively managed ETF, with $7.2 billion in assets.

March 1, 2012: The PIMCO Total Return ETF (BOND), which originally traded under the ticker TRXT and was managed by Bill Gross, launches on the NYSE Arca.

Jan. 25, 2013: Precidian makes its first filing for exemptive relief that would allow it to launch nontransparent actively managed ETFs.

Sept. 25, 2013: The iShares Short Maturity Bond ETF (NEAR) launches.

Feb. 24, 2015: The SPDR DoubleLine Total Return Tactical ETF (TOTL), managed by Jeff Gundlach, makes its debut on the NYSE Arca.

Feb. 26, 2016: The Eaton Vance Stock NextShares, the first exchange-traded managed fund, launches on the Nasdaq.

Aug. 17, 2016: Vanguard, the first firm to successfully market the concept of a passively managed fund, files for exemptive relief to launch actively managed ETFs roughly 40 years after the launch of the first index fund.

June 30, 2017: Year-to-date, 36% of the ETFs that launched in 2017 are classified as actively managed. Those 39 funds have cumulatively attracted $1.1 billion in assets. 

 

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