Actively managed exchange traded funds (ETFs) have historically been required to provide portfolio transparency on a daily basis — showing all of their cards, so to speak, and leaving their investment strategies vulnerable for the taking. While many ETFs have filed exemptive relief with the SEC over the years, this partial relief has only offered some form of non-transparent ETF structure and protection.
However, actively traded fund management may be on the verge of something significant. On April 8, 2019, the SEC gave notice of its intention to grant exemptive relief to Precidian Funds, LLC, which will allow them to operate a new type of actively managed ETF called ActiveShares® ETF. While it will be subject to some restrictions, the new fund will not be required to provide daily portfolio transparency. This “win” could change the active management landscape not only for ETFs but also for open-end mutual fund managers hoping to enter the ETF space.
Open-End Funds vs. Exchange Traded Funds
As a brief background, traditional open-end mutual funds are required to redeem their shares based on investors’ demands and, therefore, do not trade on a secondary exchange. Open-end mutual funds are also only able to buy and sell shares of a particular open-end fund once a day at 4 p.m.
In contrast, ETFs are a hybrid between an open-end fund and closed-end fund. ETFs continuously offer shares daily, but only in large blocks to “authorized participants” who then trade those shares on a secondary exchange throughout the day. In addition, ETFs conduct direct, in-kind transactions between the ETF and authorized participants, which can be highly beneficial from a tax standpoint. These mechanisms in place with authorized participants coupled with fully transparent portfolios have resulted in ETFs maintaining narrow bid/ask spreads on the exchanges.
For years active managers operating open-end mutual funds have shied away from stepping into the ETF world for fear of having to give away their “secret sauce” on a daily basis and risk others copying their investment strategy and front-running trades. Subsequently, many of them have missed out on the tax efficiencies and growth in assets available in the ETF space.
How ActiveShares Will Work
From an investor protection standpoint, regulators have always been concerned that without full transparency within an ETF buyers and sellers would be at a disadvantage — buying and selling shares during the day on an exchange without knowing the exact composition of the portfolio or the net asset value (NAV). As a result, ActiveShares will contain an arbitrage mechanism that will:
- Publish a real-time value of the ETF portfolio, called a “verified intraday indicative value” (VIIV), every second of the trading day; and
- Allow authorized participants to purchase and sell creation units of the ActiveShares.
In addition, instead of ETFs acting directly with authorized participants, a new party — known as an AP Representative — will serve as intermediary between ActiveShares and the authorized participants:
- The authorized participants will send/receive cash to/from the AP Representative who then will convert that cash either by buying or selling securities based on the basket of the portfolio.
- The AP Representative will have an agreement with the ETF stating it cannot disclose or misuse material nonpublic information along with additional safeguards and monitoring.
- Finally, the ActiveShares will be required to have a disclosure on the additional risks associated with the product via their registration documents, website and marketing materials. The SEC also has included that ActiveShares may be required to provide additional reports related to the product and functionality.
Limitations of ActiveShares and Other Considerations
The safeguard of the ActiveShares structure definitely mitigates the concerns of mutual fund managers. However, there are some limitations on the use of this new product to be aware of:
- ActiveShares will invest only in ETFs and exchange-traded notes, common stocks, preferred stocks, ADRs, REITs, commodity pools, metals trusts, currency trusts and futures that trade contemporaneously on a U.S. exchange, and will not allow leverage or short positions. Therefore, for fixed income, long/short, global and emerging fund managers, this structure will not work.
- In addition, all of the positions must have a “readily available market price” at the time of purchase; however, if a position becomes illiquid or “fair valued,” that security will be required to be disclosed publically.
- On the tax side, the risk related to other ETFs in the marketplace is the ability to use “custom baskets” for creations and redemptions. For the ActiveShares product, all creations and redemptions will be based on a pro rata slice of the ActiveShares portfolio holdings, which could potentially be less tax efficient. However, this would still be more efficient than the current way in which an active manager operates an open-end mutual fund.
- Key questions that still remain include whether this structure will be adopted by the investor marketplace and whether the safeguards the structure provides will operate as intended.
Certainly, ActiveShares is an exciting development for ETFs, but perhaps even more exciting is the potential opportunity for traditional active asset managers, as this new structure may finally be the gateway for them to enter the growing ETF market.
Please contact a member of your service team, or contact Brett Eichenberger at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.