4 Things to Know About Non-Transparent Active ETFs

Journal of Financial Planning; November 2014


Matt Hougan is president of ETF.com, where he oversees the company’s editorial, data and analytics efforts, and conferences.

What do you think when someone says “exchange-traded fund”? If you’re me, you think “low-cost.” Then you think that ETFs are index funds, they’re transparent, and a lot of them trade at penny-wide spreads.

Throw all that out the window, because the ETF world is about to be turned upside down.

For the past five years, a cadre of ETF evangelists have been trying to find ways to shoehorn old-school actively managed mutual funds into the new-school ETF wrapper. The challenge is simple: most active managers do not want to tell the world what stocks they own on a real-time basis. But by law, all active ETFs must disclose their full portfolios at the close of each trading day, and there are good reasons for that.

ETFs trade at tight spreads and close to fair value primarily because big market makers are able to look at and compare the price of the ETF and the stocks it holds. If an ETF trades above or below the value of its holdings, market makers can arbitrage the difference away by creating or destroying shares of the ETF. But if the portfolio is non-transparent, what do the market makers compare the ETF with?

While exact methodologies differ, most proposals for non-transparent active ETFs center on the idea of having a “proxy portfolio” that tracks the value of the real portfolio. Market makers won’t see what the ETF really holds, but they will see what the proxy portfolio holds.

This idea has been standing at the SEC for so long that it’s a running joke. But recent filings suggest that the time has come. At ETF.com, we’re predicting that the first non-transparent active ETF will be approved this year. Here are four key points to know about these new products:

The structures are basically sound. We spend all day combing through prospectuses at ETF.com, and only about 20 percent of us think we understand how these things work. That said, our read—and the read of lawyers we know and trust—suggests that the structures are sound. I suspect we’ll see a lot of bad and confusing reporting about these structures in the press, because they are complex and reporters are in a hurry. If you’re cautious, don’t rush to buy them; wait and let the market work out the kinks.

Trading will be wider than usual, but not terrible. A lot of the concern around these funds centers on whether they will trade at reasonable spreads. If market makers can’t see exactly what they’re buying, how will they make markets in them? I had these concerns myself, but the truth is, they flatter market makers. I suspect that most of the non-transparent active ETFs we see launched will be fairly plain-vanilla U.S. equity funds. Assuming the ETFs are relatively well diversified, market makers will be able to hedge them well enough using standard hedges. Will they trade at penny spreads? Not initially. Will they widen out when the markets get volatile? Of course. They will be systematically worse than transparent ETFs of a similar size, but they won’t be disasters, and most of them will trade well enough.

They will be better than regular active mutual funds. Assuming these ETFs launch, they will never be as cheap or trade as well as the S&P 500 SPDRs (SPY), which charges 0.09 percent a year and trades with 0.01 percent spreads. But the inherent efficiencies of the ETF structure mean they should be cheaper than traditional mutual funds, and that’s the whole point. History suggests that an ETF will cost about the same as the institutional share classes of the same mutual fund. That means that all investors get the same awesome deal usually reserved only for the big guys. When you add that ETFs are significantly more tax-efficient than mutual funds, it’s a winning combination. 

But they’ll still be active mutual funds. Don’t assume all ETFs are good. There are plenty of bad ETFs out there, and with the advent on non-transparent active ETFs, there will be more. They’ll be better than traditional, active mutual funds, and some of them will be great. But most actively managed mutual funds trail the market and nothing about being an ETF will change that. 

We could be wrong about when non-transparent active ETFs will launch. In fact, they may never launch. But if they do, this is the short guide: they’ll be better than active mutual funds, but they’ll still be actively managed funds.