What are active non-transparent ETFs?

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When people talk about active exchange traded funds they are referring to two broad types of actively managed ETFs. Both differ from traditional passively managed ETFs because they do not track a pre-determined basket of securities and nor do they aim to replicate the performance of their chosen index, for example the S&P 500, as closely as possible.

Instead an active ETF fund manager makes active choices and regular changes to the securities the ETF is invested in with the aim of outperforming its benchmark. 

How do smart beta ETFs differ from active ETFs?

The first move towards active investment strategies within an ETF wrapper came with so-called smart beta products, which seek to achieve outperformance by reweighting the underlying index with a new rules-based approach such as following momentum or choosing securities based on their value.

However, smart beta ETFs are still rules based even if they no longer follow a simple market capitalisation-weighted index. The rules for smart beta products are pre-determined and the portfolio will change according to the rules — for example value-based, or momentum strategy ETFs will adjust their weightings of their constituents depending on their price/earnings ratio or whether the constituents are rising or falling in price.

How active ETFs have developed

The first truly active ETF was launched in 2008. The aim was to allow an active fund manager to implement their own strategies while using the ETF wrapper. They have been slow to take off, however, with active ETFs accounting for a tiny fraction of ETF assets under management. 

Their slow growth might be due to their traditional structure. Traditional active ETFs, like their passive counterparts, report their positions daily and are priced throughout the day.

The second variety is the semi-transparent or non-transparent active ETF. This type of vehicle was only approved by the Securities and Exchange Commission in 2019 and allows fund managers to keep the content of their ETF portfolio hidden on a daily basis, reporting their contents as infrequently as every month or every quarter.

Which kind of active ETF is better for investors?

Traditional active ETFs have been slow to take off because their requirement for transparency meant any investor could see what the fund was invested in and how much of those securities it owned on a daily basis. This meant other investors were able to “front run” the funds.

It also meant that a mutual fund following the same strategy represented a potential advantage because it only had to reveal its portfolio infrequently.

In contrast to traditional active ETFs, managers of transparent and semi or non-transparent active ETFs are able to take positions without them being visible on a daily basis to the rest of the market. Many industry participants say this new model, if it becomes widely adopted, could transform the industry and accelerate the closure of mutual funds.

It is important to note, however, that both traditional active ETFs and the newer, less transparent varieties tend to come with higher costs than their traditional index-tracking counterparts.

How do active non-transparent ETFs work?

At the time of writing, less transparent active ETFs had only been approved in North America and Australia. In Europe, regulators have been reluctant to press ahead, according to HANetf, a white-label ETF provider, because they feared authorised participants would have privileged information opening up the possibility of market abuse.

There are several different non-transparent structures in the US.

Some providers have adopted a model which use an intermediary called an authorised participant representative (APR) to facilitate the creation and redemption mechanism. When an authorised participant wants to create shares, an intermediary, which knows the real content of the ETF, buys the stocks in the creation basket and delivers them to the sponsor which creates the ETF shares that are then passed to the authorised participants.

When the AP wants to redeem shares, the intermediary receives the basket of securities, sells them using the confidential account and passes the proceeds to the AP. To induce the APs to participate, this model relies on an intraday indicative value which is updated several times a minute.

Another model requires the ETFs to reveal a proxy basket of securities every day. The holdings of the basket overlap, but are not identical to, the actual portfolio.

A further model discloses all the holdings in the ETF, but not how much of each security is being held.

One problem with opacity is that fewer authorised participants, which create or redeem shares in the ETF to manage demand, or market makers, which ensure liquidity and provide pricing, will be aware of the exact securities that underlie the portfolios. Experts are still divided on whether this will make a substantive difference to retail investors.

Another potential problem is higher transaction costs. Active non-transparent and semi-transparent ETF providers are required to provide additional information to help the market price their funds, but as there is still less information than for traditional ETFs bid-ask spreads could end up being wider, generating higher transaction costs.

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