Transparency can create a clear line of sight, says Matt Lewis, VP, American Century Investments. How does it relate to ETF products and how has it helped develop the industry?
2020 has arrived and with it, endless “clear vision” puns. Don’t get me wrong--transparency has its benefits. You know what you're getting when you have a clear line of sight. I like to think transparency played a role in the rapid rise in exchange-traded funds (ETFs) popularity. Most traditional ETFs simply mimic broad market indices, so investors always know what their fund owns.
In hindsight: 2020
Yet, in other ways, transparency can be limiting. Daily disclosure requirements keep some proprietary strategies out of the ETF space altogether. Investment managers who have taken the time to build strategies around deep, fundamental research typically don’t want to give away their secret sauce.
Worse, they don’t want opportunities wiped away by competitors who simply copy their strategies and front run[1] their purchases. As a result, investors had limited choices in the ETF space. Until now.
Unique features of semitransparent ETFs
The SEC approved the first semitransparent ETF structure, Precidian ActiveShares®, in May 2019, opening the door for new product options. In December 2019, the SEC approved additional structures known as “proxy baskets”.
These revolutionary new structures help bridge the cost and tax efficiencies of ETFs with the benefits of active management by revising the disclosure rules. Instead of disclosing their full list of holdings daily, investment managers publicly share their holdings monthly or quarterly (with a lag) depending on their disclosure policy.
While this helps preserve the managers’ strategies and process, it, with additional innovative features of the models, still provides enough transparency for market participants to quote and trade the funds.
How can a new model work for transparent ETFs?
The Precidian model provides investors an indicative value of the ETF, even though it doesn’t disclose the daily holdings. Here’s how that works:
1. VIIV AGENT CALCULATES THE INTRADAY ETF VALUE
The VIIV agent—typically a financial data services provider—is one of only a few parties that know the fund’s holdings. The agent uses that information to calculate an intra-day value for the ETF in one-second intervals throughout the trading day. The value is disseminated to the Consolidated Tape for all to see. Market participants can then use the intraday value as an input into their ETF quotes and trading the shares.
2. APRs ACQUIRE THE SECURITIES
The AP representative (APR)—a registered broker/dealer—acquires the securities held in the ETF on behalf of the authorized participant (AP). The AP will provide cash, which the APR uses to buy the portfolio holdings. The APR then facilitates in-kind transfers into and out of the fund, preserving the tax-efficient benefits found in most ETFs. When the APR conducts transactions in cash with the AP, it prevents the AP from seeing the underlying portfolio holdings. This helps preserve the portfolio manager’s proprietary strategy since only the VIIV agent and APRs know the specific daily portfolio holdings outside of the asset manager and custodian.
3. DAILY NAVS ARE PUBLISHED
Semitransparent ETFs publish their NAVs daily. Investors also have access to the daily and historical return difference between the NAV and the VIIV.
The proxy basket models
Proxy basket models allow investors and market participants to see a variation of what holdings exist in the fund. Those variations could be a sampling of the fund’s holdings or new, similar holdings.
They may also use other ETFs, futures or swaps—each of the five proxy basket structures are a little bit different. In the end, they all give some approximation of the fund that is designed to closely follow the holdings on a daily basis. This gives investors some level of transparency into the portfolio holdings’ characteristics and how they move within the market.
Similar to the ActiveShares® model, NAVs are published on a daily basis and investors will have access to historical return differences between the proxy baskets and the actual portfolio.
Looking ahead
This year marks a new milestone for the ETF universe. Asset flows tell us clients are increasingly incorporating ETFs in their portfolios to get the exposures they want. Up until this point, those ETFs have been largely passive products. Active ETFs exist largely in the fixed income space yet remain a limited portion of the overall ETF universe.
I think semitransparent ETFs will dramatically change that landscape. Asset managers will finally be able to bring forward their best insights to this increasingly popular investment vehicle, without fear of front running. I believe this will inspire innovative products and more choice for investors in the decade ahead.
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[1]Front-running is the practice of a broker or trader making trades just before a large non-publicized order to gain an economic advantage.