Spotlight on Semi-Transparent ETFs

The highly anticipated regulatory approval of a new class of semi-transparent active exchange- traded funds (ETFs) has captured the imagination of the market— prompting investors to think of ETFs in a whole new way.

On May 20, 2019, the Securities and Exchange Commission (SEC) gave its final approval for Precidian Investments’ ActiveSharesSM structure. This actively managed ETF does not require the sponsor to publish daily portfolio holdings to the market, yet still trades like a traditional ETF. While Precidian must still receive exchange listing approval by the SEC Division of Trading and Markets, the product could be in market by the end of 2019.

Actively managed ETFs are not new. They were introduced in 2008 with the launch of the Bear Stearns Current Yield ETF. But until now, they have never enjoyed such regulatory protection of the underlying investment ideas. ETF sponsors were required to fully disclose their holdings daily, which some could argue constrained the overall growth of the active category. Today, active strategies represent only a small portion of total ETF assets. With the regulatory support signaled by the Precidian approval, this may now change, as active equity managers who have been eyeing the extraordinary growth of ETFs move off the sidelines and into the market.

At State Street, we have been involved with the creators and licensees of the ActiveShares structure for several years, helping conceptualize and develop the operating model and workflows to service the product. We have also engaged with SEC staff and commissioners to educate them on our automated servicing capabilities.

While much of how the market will develop in response to this major milestone is still unknown, this is an exciting opportunity for investors. We sat down with Frank Koudelka and Jeff Sardinha, two of State Street’s ETF specialists, to hear how they’re responding to some of the most common questions they have received so far.

Why is this industry development significant?

It opens the door to a range of active managers who previously were not comfortable disclosing their best ideas to the wider market. It also gives managers assurance that they can protect their proprietary intellectual property while still taking advantage of the many benefits of an ETF structure. While we’ve seen plenty of activity in the active fixed-income ETF space, we’ve only just scratched the surface of active equity ETFs. We expect the Precidian approval to accelerate innovation in that category, as industry participants now have favorable regulatory guidance to proceed.

The initial approval for semi-transparent active shares comes at an especially poignant time in the market. Active mutual funds have seen declining market share and face heightened expectations from investors demanding better

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fees and liquidity. Investors have been drawn to ETFs for their liquidity, ease of trading and cost efficiency. But after a decade of rapid growth and significant market concentration amongst the largest providers, many in the industry have started to question what opportunities are left for new market entrants and new products. We expect the Precidian approval will usher in more opportunities for other players to enter the market with innovative ideas for ETF products.

What should managers know about the differences between traditional ETFs and semi-transparent active ETFs?

With traditional ETFs, only an authorized participant (AP) has control of the trading process. The semi-transparent active structure introduces the new role of AP representative, who is independent of the AP and the fund. The AP representative will use confidential accounts to compile the inventory necessary to complete the in-kind delivery to the fund, thereby shielding the information from the broader market. In terms of required holdings disclosure, non-transparent active shares will follow the quarterly reporting practice of open-end mutual funds.

Another major difference is how portfolio valuation works. The majority of traditional ETFs disclose portfolio holdings daily, publishing an intraday indicative value (IIV) every 15 seconds. Semi-transparent active shares will increase this frequency and add a verification process, publishing a verified IIV every second of the trading day on the consolidated tape, which is confirmed by the calculation agent to minimize discrepancies.

When managers are considering if semi-transparent active ETFs are right for their business, they should know that active share ETFs can only be composed of US exchange-listed securities. For managers that specialize in the foreign market, this model is not available in its current structure.

How will distributors and broker-dealers handle similar products, if one is structured as a mutual fund and the other an ETF?

Much of this remains to be seen, and we’re carefully monitoring how the industry is evolving. In the US, managers will almost certainly experience an acceleration of the long-standing struggle for limited shelf space. If the underlying investment approaches are identical, lower-cost products are likely to win over their more expensive counterparts.

In light of this, managers will have to think very carefully about how a new ETF would work within the context of their wider product offering. They can’t simply clone an investment product that didn’t work well in a mutual fund structure and expect that it will work as an ETF. Instead, they should be able to articulate how the product will deliver unique value and make sure that message resonates with advisors and investors.

Investors are drawn to ETFs for their liquidity, ease of trading and cost efficiency

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1 ETFGI Canadian ETF Insights as of June 30, 2019. 2019 flows are annualized.

In light of the industry-wide shift to passive investing, will active equity ETFs be successful? Why or why not?

We think the future is bright for active equity ETFs. It’s an exciting time for innovation in the asset management industry and a positive for investors, who benefit from a wider range of choices and more freedom in how they construct their portfolios.

Looking at the Canadian market as an example, semi-transparent active ETFs have outgrown passive ETFs. Actively managed ETFs were 44 percent of Canadian ETF flows in 2018 and have made up 44 percent in 2019 through May.1 All of the Canadian banks now have an ETF lineup and we’ve seen global managers recently enter the Canadian market.

So much is happening across the industry right now—zero-fee ETFs, smart beta, and plenty of interest in thematic strategies, as funds focus more on alternatives and economic, social and governance issues. We think the regulatory approval of ActiveShares will help breathe new life and new ideas into what is already an exciting part of the market.

FRANK KOUDELKA

+1 617 662 4749

francis.koudelka@statestreet.com

Frank Koudelka is a senior vice president for State Street’s Product team, responsible for ETF global product development strategy. His expertise in ETFs and mutual funds helps clients better understand global industry trends and how ETFs have become a disruptive force of innovation.

JEFF SARDINHA

+1 617 866 7283

jsardinha@statestreet.com

Jeff Sardinha is a vice president on State Street’s ETF Bridge team, working directly with participants in the ETF ecosystem to design and implement operating models for ETFs and keep them current on market developments. He had a direct role in helping build the operational framework for semi-transparent active ETFs.

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