Project Description

Non-transparent ETFs


There has been a meteoric rise in ETFs over the past decade plus, but the overwhelming majority of those ETF assets are in passively managed index ETFs, funds that track a market or industry index with a fixed portfolio.

ETFs publish their portfolio composition file every night, which means anyone with access to the internet can see exactly what a portfolio manager in an ETF has done the previous trading day.

Because of this, actively managed ETFs have been slower to come to market and raise assets. Many portfolio managers balk at the idea of laying bare their investment decision-making to the public, feeling that full transparency diminishes the value of the intellectual property the portfolio manager’s investment selection methodology brings to the table.

Current proposed solutions

Many in the investment management industry believe actively managed ETFs will only thrive once there is some protection for the portfolio management process. Several firms have filed applications with the SEC to modify the process by which ETFs disclose their holdings. In order to get the green light from the SEC, each applicant has had to show how they intend to balance the principle of transparency that has been a hallmark of ETFs to date with the objective of concealing a portion of the investment strategy process to appeal to active portfolio managers.

The market makers for the ETF are a critical component. The market maker must have a market value of the ETF on a current basis in order to make a bid-ask spread to ETF shareholders to purchase or sell their shares.

The applicants have dealt with this situation in various ways. One applicant does not disclose the actual portfolio to any party other than a designated firm that is given the full portfolio information and the licensed authority to transact on that ETF’s basket of securities for shareholder settlement. This method is the least transparent of the proposed solutions and requires a new method of ETF basket execution.

Another applicant’s proposal includes all the portfolio securities in the ETF’s public disclosure (i.e. the creation basket), however under their structure a security’s % weightings in the creation basket will always differ from its correct % weighting in the actual ETF portfolio.  This basket structure fully hides a fund manager’s portfolio and trading strategy, but still provides authorized participants (APs) and market makers with the transparency they require to conduct efficient trading under all market conditions.

Another applicant’s model allows for the public disclosure to be partially incomplete, using proxy securities. As an example, the actual portfolio might contain ExxonMobil, but the disclosed basket might substitute British Petroleum. The securities are not identical, and the public will not know which security is actually in the portfolio, but the historical correlation between the two similar securities poses a manageable tracking risk for market makers and APs transacting with the ETF.

Other models have been contemplated and will no doubt be proposed.

It remains to be seen whether the non-transparent models will attract active portfolio managers, many of whom have been very successful in managing open-end traditional mutual funds, into the ETF world.

Nottingham intends to enter into license agreements with one or more of the models in order to work with actively managed portfolio managers in creating non-transparent ETFs.