Regulators sent a message to the investment management community last month that they are ready to embrace innovation, but the managers have their collective guard up. U.S investment firm Eaton Vance won approval from the SEC to launch a new kind of investment product: a non-transparent type of Exchange-Traded Fund (ETF) called an Exchange-Traded Managed Fund (ETMF). Sort of a next-generation mutual fund, the ETMF is a completely different type of animal than the “blind trust” type of ETF. Both provide opacity for the portfolio manager, but the latter has numerous pricing and trading uncertainties and potential conflicts of interest.
The SEC was cautious. Only days before the approval, the regulator rejected a different type of non-transparent ETF characterized by its utilization of a blind trust and unique redemption process. The SEC apparently didnt care much for the funds plans to ensure that ETF market prices would not deviate significantly from their net asset value (NAV), and deemed that they failed to meet the public interest.
The SECs basic problems with the funds were threefold. First, a blind trust and its opaqueness seem to serve the interests of the portfolio manager more than of market participants and investors. Second, the funds rely heavily on the intraday indicative net asset value (IIV), a calculated price thats 15 seconds old by the time it updates; an ETF trader would never rely on an intraday indicative value for price discovery and hedging of risk and exposures. And third, these investment products are not transparent; the SEC heavily favors transparency.
The lack of transparency is likely to discourage participation by ETF market-makers. Their role is critical in the ETF ecosystem to provide liquidity and price discovery, and ensure close linkage between the ETF price and its NAV. The opacity also impacts their ability to effectively manage their risk. ETF market-makers would have needed to figure out how the ETFs IIV would move in relation to various market forces such as interest rates, commodity prices and broad-based indexes.
The SEC also expressed little faith that these products would hold up during periods of market stress, when the ability to quickly obtain fair-value pricing is especially important.
Concerns abound. For one, the SEC has sought to impose more disclosure requirements on mutual funds in favor of more transparency, not less. Two, nontransparent active ETFs could prove to be fertile ground for risky and illiquid assets that could sprout the type of systemic risk that led to the 2008 financial crisis. Three, mutual funds understood fees could be replaced with a mix of explicit and implicit costs including increased transaction costs, wide bid/ask spreads and new forms of arbitrage. And finally, at the core of the SECs concerns is the potential for these ETFs to deviate from NAV. ETF premiums and discounts would increase and hinder fair-value price discovery.
Still, non-transparent active ETF products are hailed by some as potential game-changers for the investment industry, and industry advocates remain optimistic. So expect to see more attempts to apply for SEC approval.
ETF sponsors have plenty of incentive to see these products come to fruition, as there is little left of the market to index, and an active manager can command higher fees than a passive manager. There will also always be an appetite for actively managed portfolios despite their long-term track record compared to passive indexing strategies.
A New ETF Offering
This isnt to say that non-transparent funds dont potentially have value. The transition from traditional mutual funds into an active ETF structure should provide net-neutral to net-positive outcomes for investors. The investor would simply be replacing one relatively non-transparent investment product (mutual funds) with another (non-transparent active ETFs). The ETF structure should benefit mutual fund investors with advantages such as tax efficiencies, lower costs and improved tracking.
For the portfolio manager, it is easy to understand his or her desire to protect the secret sauce. The structure also inhibits other market participants from profiting from portfolio changes at the expense of the fund.
The investor and media frenzy witnessed with the me-too launches of leveraged and inverse ETFs provided a cautionary tale for what happens when poorly understood − and arguably unnecessary − investment products are put in front of investors. This time, the SEC took a proactive and cautious position.
As for the ETF sponsors, it probably didnt help the pitch to lead with terms like nontransparent, active and blind. These are not exactly what an investor wants to see when deciding where to invest.
Spencer Mindlin is an analyst with Aite Group who focuses on capital markets technology.
