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Nontransparency may be a game changer for the fund industry

After the SEC approved the first-ever nontranparent ETF from American Century last year, a wave of greenlights followed for firms including T. Rowe Price, Natixis and Fidelity.
After the SEC approved the first-ever nontranparent ETF from American Century last year, a wave of greenlights followed for firms including T. Rowe Price, Natixis and Fidelity.

American Century Investments was the first asset manager to get SEC approval to register a nontransparent ETF last year. A wave of greenlights followed for firms including T. Rowe Price, Natixis and Fidelity.

Unlike the traditional ETF, this new fund can trade without daily disclosure of its securities holdings. Asset managers and experts spoke with Money Management Executive about this new ETF trend and others to look out for this year.

Nottingham CEO Kip Meadows says managers may benefit from the new structure because "selection of securities is the intellectual property for which they are paid fees."

Blue Tractor co-founder Simon Goulet agrees that it protects "the intellectual alpha of active managers."

A comeback year for active management?
Jay Rhame, CEO, Reaves Asset Management
Investors and financial advisors are likely to search out ETFs that can successfully navigate this environment.

In a bull market, it's hard to do much better than low-cost, passive funds, especially when the marginal dollar is invested in passive funds.

Where active management can shine is in volatile and tough markets. The various skills used in fundamental analysis, such as determining creditworthiness and assessing growth opportunities, can help to avoid the most precarious situations. The riskiest stocks can often be the best performers in good markets because there is so much operational leverage.

In bad markets, however, sometimes there is no bottom. The bankruptcy of Pacific Gas and Electric highlighted the issues faced by passive funds when owning risky stocks. The shares plummeted 86% from a high on Nov. 7, 2018, through Jan. 16, 2019, when the S&P 500 decided to remove the company from the index.

The passive investor was stuck holding the stock until the index made the change, long after it became clear the company would seek bankruptcy protection.
Active funds were nimble and avoided the disastrous performance, ultimately saving investors a great deal of money.

If volatility does return in 2020, active managers could play a big role in terms of capital preservation. This could potentially make it a comeback year for active management.

Focus on ETF differentiators
Chris Buck, head of capital markets, Robo Global
Over the past decade, we've witnessed the rise of ETF strategies. Now investors look to target specific exposures or strategies that will outperform broad market indexes. In 2020, investors will increase the use of innovative strategies to complement their portfolios with the intent to manage risk through diversification and target growth.

That said, asset managers and fund issuers should keep in mind that, as product demand increases, investors will look beyond the name of the fund. Below are some tips asset managers and issuers should leverage in 2020 and beyond:

  • Articulate performance relative to broader benchmarks: At the end of the day, investors turn to thematic strategies for their growth potential beyond foundational investment accounts such as 401(k)s. Asset managers and ETF issuers must demonstrate a fund's performance against a broader benchmark, such as the S&P 500, as well as why the strategy is designed to outperform.
  • Pay attention to retail investors: With the bull market raging on, we're sitting on more cash in investment accounts than has been there in a long time. Retail investors have a plethora of funds to sort through and those that set forth simple, easy-to-digest investment objectives will stand out.
  • Develop a stronger narrative: If individual investors understand and feel connected to a theme, they will stay the course. This is the key reason thematic funds have garnered so much attention thus far, and why I believe they will continue to gain traction in the future.

As more and more thematic ETFs hit the market, it will be increasingly difficult for advisors and individual investors to differentiate one strategy from another. Issuers must focus on performance differentiators, distribution tactics and clear communication in order to stay competitive.

The trend toward nontransparent ETFs
Kip Meadows, CEO, Nottingham
ETFs are designed to trade actively on an exchange. For the market makers to offer a bid-ask offer on the exchange, there is a need for them to know what securities are in the underlying ETF portfolio.

One of the primary services provided by the exchange is to update the current market price of each of those underlying securities.

Many investment advisors balk at this level of transparency, as the selection of securities is the intellectual property for which they are paid fees. If the investing public can see exactly what is in their portfolio, updated every few seconds by the exchange, the value of that intellectual property is jeopardized.

This friction between the transparency of ETFs in structure and the desire for proprietary information drives the new nontransparent structures. Several structures have been approved, with varying levels of secrecy and transparency. At least three approved structures will be available for investment advisors wanting to start their own ETF.

The New York Stock Exchange model allows the investment advisor to substitute a limited number of securities in their published ETF basket (for quotes and issuance of new shares). The substitute securities must be similar in certain trading characteristics to be deemed a legitimate proxy.

The Blue Tractor model includes 100% of the actual securities in the portfolio, but the investment advisor may alter the published basket to alter the percentages of certain positions in the portfolio.

The Precidian model is only updated quarterly, and relies on a new third-party intermediary to monitor the portfolio for trading and basket delivery. This additional layer will be limited to a handful of authorized participants and custodians willing to add the additional layer. In 2020, it will be interesting to see whether the investment advisory community will adopt these structures which were created to answer their concerns.

Finding value in nontransparency
Simon Goulet, co-founder, Blue Tractor Group
A key characteristic propelling ETFs' growth is their inherent transparency, manifested by daily publication to the market of the securities the ETF holds. This allows investors and advisors to know what securities an ETF holds.

Portfolio transparency also allows institutional market makers and traders to fully characterize the security risks they are exposed to, permitting accurate pricing and efficient trading for the ETF in all market conditions. However, 2020 will see considerable changes in ETF choices available, because of the five new SEC-approved approaches to the nontransparent ETF. These structures facilitate active portfolio management within an ETF wrapper, conferring to investors the substantial benefits of an ETF versus an actively managed mutual fund, including lower cost, greater tax efficiency and intraday liquidity.

However, unlike a fully transparent ETF, these ETFs won't require complete daily disclosure to the market of the ETF portfolio, permitting a fund manager's alpha generation strategy to remain nontransparent. Each of the five approaches employs propriety methodologies to create the requisite obfuscation, ranging from not disclosing any portfolio securities, to more nuanced approaches that see partial or significant disclosure of securities. Each approach can be characterized by its relevant level of inherent portfolio transparency. This is important when assessing how the ETF might fare in terms of efficient markets and liquidity in all market conditions, especially volatile periods.

ETFs have moved from passive or factor-based structures to protecting the intellectual alpha of active managers. The shift from exposure to performance empowers the active manager to demonstrate value. Additional innovation is sure to follow as more active managers begin to embrace the ETF structure.

Rising tide of algos in ETFs
Alex Brown, head of product for principal trading, Itiviti
With the regulatory onslaught showing little sign of easing off in 2020, there has never been a more pressing need for financial institutions to gain a true understanding of their algos.

To ease compliance, firms have retired strategies that are legacy or least understood whilst keeping the high performing ones. At the same time, many have reviewed how these can be leveraged for other asset classes — including ETFs. A recent TABB report claimed that the major banks are seeing a sharp increase in ETF algo trading.

As the tier one players become increasingly more sophisticated in their algo trading capabilities, market participants will demand more information to help with price discovery and issuance in an increasingly competitive ETF market. With a greater number of algos being deployed specifically to tap into ETF liquidity, expect to see the leading trading venues enhance their request-for-quote-driven models in the New Year.

For market makers trading on these venues, success will be determined on who best circumnavigates ETFs with varying regulations, and who gets to grips with the fundamental differences in the negotiation workflows.

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