How Stealth ETFs Plan to Invade a $7.2 Trillion Market

One of the key features of ETFs has been transparency, with mandated daily disclosures of their holdings. While this is fine for passive ETFs that track market indices, it has made the ETF structure less than ideal for actively managed portfolios. Now a new SEC rule permits the creation of ETFs that disclose their holdings quarterly, leveling the playing field with actively managed mutual funds.

"This is a game changer for the industry,” as Jim Tambone, chief distribution officer at investment firm Fred Alger & Co., told The Wall Street Journal in a recent story. The new ETF structure, called ActiveShares, was designed and patented by Precidian Investments. About $7.2 trillion in actively-managed mutual fund assets eventually could migrate to ETFs constructed under the ActiveShares model, JPMorgan Chase analysts estimate, as reported by Bloomberg.

Key Takeaways

  • The SEC has approved new ETF structure called ActiveShares.
  • These funds will disclose their holdings quarterly, not daily.
  • ActiveShares are designed for actively managed funds.
  • They present a competitive challenge for active mutual funds.

Significance for Investors

Early licensees of ActiveShares include BlackRock Inc. (BLK), JPMorgan Chase & Co. (JPM), Capital Research, Nationwide, American Century Investments, and Legg Mason Inc. (LM), per Precidian. Legg Mason bought a minority ownership interest in Precidian in 2016, and its affiliates ClearBridge and Royce are also among the licensees.

Earlier this year, a study by research firm Morningstar Inc. tallied 2,010 U.S-based mutual funds with a collective $4.4 trillion in assets under management (AUM) that invested only in domestic stocks, as reported by Pensions & Investments. Given the growing popularity of the ETF model, which allows for continuous trading throughout the day, the advent of ActiveShares and possibly other nontransparent ETF structures poses a key threat to these mutual funds.

Until now, the daily transparency requirement for all ETFs had limited their appeal to active fund managers and their clients. By having to report their portfolios daily, active managers essentially would be losing control over their intellectual property. The fruits of their research and expertise would be put on daily display, to be copied by competing funds and individual investors alike. By contrast, the portfolio disclosures made by mutual funds can be delayed by up to 60 days after the close of a quarter.

“By the nature of the product, there are going to be wider spreads on account of the additional uncertainty--especially in the early days,” as Craig Messinger, CEO of Virtu Americas, a broker-dealer affiliate of Virtu Financial, told Bloomberg. “But we have a good idea of how to price this. You’re going to have a good universe of market makers,” he added.

Various proposals for nontransparent ETFs have been under SEC review for years, per the Journal. In 2005, ETF pioneers Gary Gastineau and Todd Broms came up with a design that eventually won approval, and has been used by Eaton Vance Corp. (EV). Mutual fund giant Fidelity Investments submitted a confidential filing on its own design in 2007, and is still waiting for approval.

Looking Ahead

Some observers are skeptical about the benefits for investors. “I’m never going to get very enthusiastic about a product designed for the sole purpose of asset gathering,” as Leo Kelly III, CEO of wealth management firm Verdence Capital Advisors, told the Journal.

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