Stockpickers fight back by modifying the design of ETFs
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The investment industry is being transformed as disenchantment with the high fees and inconsistent performance of actively managed strategies fuels a shift by investors into index-tracking exchange traded funds.
About $4.3tn in new cash has been ploughed into low-cost passively managed ETFs since 2009, leaving many traditional active managers who try to pick winning stocks struggling to respond. Stockpickers believe they have found a way to fight back by modifying the design of ETFs to suit actively managed investment strategies.
The Securities and Exchange Commission, the US regulator, granted approval last year for several semi-transparent and non-transparent ETF models, which do not have to disclose their holdings daily. This will allow active managers to protect their trading strategies or the “secret sauce” which they hope will deliver outperformance. Hedge funds will not be able to frontrun trades or freeride the ideas that active managers use in these non-transparent ETF vehicles.
“This [decision by the SEC] is a huge boost for the active ETF market. The introduction of non-transparent active ETFs should be viewed as a natural, healthy and desirable development,” said Hector McNeil, co-founder and chief executive of HANetf, an investment platform that helps ETF industry entrants.
Many observers believed the transparency offered by index-tracking ETFs, which publish details of their holdings daily, had been one of the key attractions for investors. But Mr McNeil said investors would soon accept non-transparent ETFs, pointing to the growth already achieved by “smart beta” ETFs, which offered a blend of active and passive management strategies.
“The creation of non-transparent active ETFs could unleash a wave of innovation and growth and, more importantly, offer tremendous benefits for end investors across Europe,” he said.
Invesco, the fourth largest ETF provider, aims to launch non-transparent active ETFs this year. Anna Paglia, Invesco’s global head of ETFs, said non-transparent ETFs would offer lower-cost, more tax-efficient alternatives to US domestic equity mutual funds.
US-listed ETFs do not pay fees for marketing and distribution, which are incurred by investors in mutual funds. ETFs also do not pay fees to transfer agents, who provide services to fund shareholders.
But Ms Paglia acknowledged “performance will be key for the acceptance of non-transparent ETFs”.
The first actively managed ETF was launched in 2008. Close to 900 are now listed globally and most disclose their holdings daily. Assets held in active ETFs stood at just $194.2bn in July, according to ETFGI, a London-based consultancy. Investor interest has picked up with inflows reaching $35.4bn by the end of July, compared with the $42.1bn gathered over 2019.
Just eight of the new non-transparent ETFs have been listed in the US and they have combined assets of $375m.
Growth will depend on whether investors find the extra complexities of non-transparent ETFs palatable.
Fidelity, the Boston-based asset manager, has designed a model that will use a proxy basket of similar holdings to track the active ETF. This is to ensure the underlying strategy is kept secret. But it could raise costs for end investors as brokers tend to charge more when they have less information to protect themselves from potential losses.
How active ETFs will perform in more volatile conditions also poses concerns. Darby Nielson, managing director of equity research at Fidelity, warned transactions based on the proxy basket “might not match” the value of the active ETF portfolio, especially in uncertain markets.
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A rival model designed by Precidian relies on an extra layer of trading between the investor and the ETF manager. So-called authorised participant representatives, also known as trusted agents, using confidential accounts will process creation and redemption orders for ETF units for large institutional investors.
This could lead to questions from investors as to whether they have received a fair deal.
Such complexities do not appear to have deterred potential partners, including BlackRock, and JPMorgan, who have acquired licences that permit them to use Precidian’s model.
Deborah Fuhr, the founder of ETFGI, said the new non-transparent structure did not solve the main problem confronting active managers.
“The big challenge facing all active managers is that most have not been able to deliver alpha [market-beating returns] consistently,” she said.
Although the non-transparent ETFs would have the ability to cut fees, many investors would want these vehicles to establish a performance record and accumulate assets of at least $100m before they would consider making an allocation, she added.