Nontransparent active ETFs can finally take flight

Nontransparent active ETFs can finally take flight

SEC decision lets fund managers keep their playbook under wraps

Nontransparent active ETFs can finally take flight

Imagine being the head coach of a football team. You draw up a playbook with innovative schemes and strategies. You even set the order in which the first 20 plays will be called. And then you have to hand the playbook over to your opponent a day before the game! Now that doesn’t seem fair does it?

Well that essentially was the predicament that active exchange-traded fund (ETF) managers were in since these investment vehicles began to skyrocket in popularity. But that may be about to change dramatically thanks to a recent SEC ruling (technically referred to as exemptive relief). Active ETF managers no longer have to tip their hands and reveal the various components that make up their ETF baskets; they can keep their playbook hidden from the public – and the competition – in a “nontransparent” ETF.

Download the paper to learn more about:

  • Structuring a nontransparent ETF
  • Top 4 things fund managers should anticipate
  • Keys to scoring with an ETF
  • Executing an effective two-minute drill (i.e., what active fund managers should do next)

Structuring a nontransparent ETF

The SEC approved the nontransparent ETF model because it was structured in a way that satisfied two key principles:

  1. Investors would benefit from it.
  2. The ETF shares could be accurately priced by a third party.

The nontransparent ETF method that the SEC approved, referred to as the Precidian model, called for the ETF to appoint a “trusted agent” who has access to all of the ETF portfolio holdings. This allows the trusted agent to accurately price the ETF shares and support market liquidity.

Because the portfolio make-up is kept confidential, other trading firms are prevented from “front-running” and bidding up the price of the underlying securities or other assets before the nontransparent ETF can buy them. And just like a mutual fund, the public is made aware of ETF holdings on a quarterly basis.

Top four things fund managers should anticipate

Regardless of whether you’re currently managing a passive ETF, mutual fund, alternative investment or hedge fund, or are just breaking into the ETF space, here are some things to consider before forming and operating a nontransparent ETF:

  • More responsibility: It takes more work and entails greater responsibility to coordinate trading activities with an actively managed ETF, than it does with traditional, passive ETFs.
  • Less management revenue: Actively managed ETFs generate comparatively less fee revenue than actively managed mutual funds with the same amount of assets under management. So it’s critical to optimize your operating model and keep a close eye on expenses.
  • Potentially less support: Your current service providers (e.g., custodian, fund accounting, transfer agent) may not yet be prepared to support nontransparent ETFs. This is something you’ll need to confirm before forming a nontransparent ETF.
  • A longer application process: The length of the application process for ETFs often varies by the complexity and types of asset anticipated to be held in the ETF. So, for example, a strategy to hold derivatives, leverage, hedging, and non-public securities assets in an ETF will likely result in a longer time period to gain SEC approval (or may fail to gain approval altogether).

Keys to scoring with an ETF

While there are no guarantees for ETF success, there are steps to take that may increase the likelihood of scoring a touchdown:

  • Understand the ETF landscape thoroughly, including your competitors’ strengths, weaknesses, and tactics.
  • Offer a unique, differentiated product that connects with investors, and develop a compelling “elevator speech” to explain the product to appropriate audiences.
    • Make sure your ETF has broad appeal, even if it’s in a niche market. An ETF that’s only appropriate for a few large clients can lead to problems down the road.
  • Realistically assess the fixed costs and run rate it will take to launch and maintain the ETF for at least 18 months (or until it gains traction). In addition, consider the amount and timing of seed capital to show activity in the fund, versus seeding the entire amount at launch.
  • Make sure that you have the right talent, experience, and track record to execute on the investment strategy you’ve selected.
  • Lock in your operations, technology, and sales platforms, and your custodian and distribution contracts.
    • No matter how good your product is, your ETF is likely to fall short of the goal line unless you can find a way to get it distributed.
  • Create a competitive and predictable fee structure.
  • Build in options that allow you to be more nimble and agile than your competitors.

Executing an effective two-minute drill

It’s anticipated that nearly all active fund managers will at least consider offering their active investment strategies as ETFs, and many have already started the process. So if you’re thinking about entering the nontransparent ETF market, you’ll want to move quickly and put your plan in place before the space becomes too crowded.

“Time is of the essence. Waiting even 18 month may to too late,” cautioned Penman. “The special ETF market you’re targeting may be saturated by then.”

So it’s time for you to go into the two minute drill. This means determining how to best structure your nontransparent ETF so it’s well-positioned to gain SEC approval, line up your service providers and distribution channels, determine who your potential investors are, and formulate your marketing plan.

Being the first to market with a new ETF asset class or industry sub-sector can work to your advantage and help you potentially take a leading position in that investment strategy.

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