Exchange Thoughts - New Wave of Active ETFs Shield the Secret Sauce

December 11, 2019
Following the US Securities and Exchange Commission’s (SEC) approval of Precidian’s ActiveShares model in May, four proxy-based, semi-transparent ETF structures were given notice of approval by the SEC. The new ETF structures could herald a new era of active ETFs.

On December 10, the SEC approved new proxy-based, semi-transparent active ETF structures from Natixis/New York Stock Exchange (NYSE), T.Rowe Price, Fidelity, and Blue Tractor Group. While each of the products is unique, they all use “proxy baskets” to avoid the possibility that investors will use disclosed information about an ETF’s holdings to front run the strategy. These structures may provide a compelling option for active managers to enter the ETF market without revealing their “secret sauce.” In this edition of Exchange Thoughts, we break down the different features of these active structures.

Transparency in ETFs 

Generally, managers are required to disclose the holdings of their ETF, both the underlying securities it contains and their relative weightings in the fund, every morning prior to market open. For active managers, the concern around this level of transparency is that it may give away the proprietary strategy that the manager has developed, at the expense of the fund and shareholders.

While the approval of Precidian’s ActiveSharesTM model in May opened the door to non-transparent active ETFs, there is a distinction between this new wave of ETF structures and the Precidian model. These new ETF structures introduce the concept of a representative proxy basket, which enable managers to camouflage or shield the underlying securities held in the ETF. These proxy baskets are designed to offer enough detail so authorized participants (APs) and market makers can efficiently trade the portfolio and hedge their exposure without disclosing the true fund holdings. Additionally, the proxy portfolios will be used by APs to support the creation and redemption of ETF shares. Asset managers considering these newly approved structures, should be aware of the differences in how the proxy basket is derived and the added data that needs to be disclosed to investors. Like Precidian’s ActiveShares, these four structures are limited to securities that trade contemporaneously with the US market.

Precidian’s ActiveShares Non-Transparent ETF Model

ActiveShares ETF structure allows managers to shield their investment strategy to investors and the public. Rather than delivering the funds’ basket to the street each day, ActiveShares ETFs will only send the basket to a new entity called an authorized participant representative (APR). APRs are the only entities outside of the fund’s manager, custodian, and verified intraday indicative value (VIIV) agent to see the ETF’s underlying positions each day. The APR will use a confidential account to facilitate creation and redemption orders placed by the funds’ APs. The APR will also manage in-kind delivery of the basket constituents and ETF shares. ActiveShares, like all of these new “active” product structures, is expected to offer investors the same key benefits as traditional ETFs, such as tax and cost efficiency.

Precidian Investments ActiveShares
  • There is a new role. Previously, APs executed creating and redemption orders directly with the ETF's. While APs will still place the order, a new third party entity, the APr, WILL USE confidential accounts to trade the basket securities on behalf of the AP and deliver the basket and shares to or from the fund.
  • Intraday valuation goes a step further. ActiveShares functions similarly to existing ETFs by requiring a snapshot of the funds' portfolio throughout the day. While all other ETFs publish an intraday indicative value (IIV) every 15 seconds. ActiveShares will take this requirement a step further and publish the VIIV every second.
  • Creation unit size is smaller then a traditional ETF. Creation unites can be as low as 5,000 shares, potentially making these products less expensive for APs to trade.

What is Natixis/NYSE Periodically-Disclosed Active ETF?  

Periodically-Disclosed Active ETFsTM will allow for efficient trading of ETF shares through a proxy portfolio methodology, owned by the NYSE. This methodology will employ a factor analysis of each ETF and its corresponding universe of eligible securities to create the proxy portfolio.  The ETF’s proxy portfolio will closely track the actual portfolio on that day and may change daily. The ETF will use a proprietary software developed by analytics company Axioma to allow market participants to assess the intraday value and associated risk of a fund’s portfolio.

Natixis/NYSE Periodically-Disclosed Active ETF
  • Uses a proxy portfolio. The Periodically-Disclosed Active ETF model employs a factor methodology to generate the proxy portfolio, which will include only securities that are eligible investments of the fund.
  • Tracking error. Tracking error between proxy and actual fund must fall below 1 percent and the overlap between the proxy and fund is published to the fund's website.
  • Intraday Indicative Value (IIV). Publishes every 15 seconds based on the proxy.
  • Proprietary Licensing. NYSE will license the software to fund advisers who want to bring to market proprietary active strategies within the Periodically-Disclosed Active ETF wrapper.

What is T.Rowe’s semi-transparent active structure?

T. Rowe’s proxy will be composed of a basket of cash and securities that is designed to closely track the daily performance of the fund’s portfolio. In addition to the proxy portfolio, each business day prior to the start of trading the fund will publish the portfolio overlap, tracking error, and the deviation between the proxy and fund NAVs on a daily and rolling one-year basis.

T. Rowe
  • Proxy Basket. The adviser will identify the proxy portfolio, which could be an index or teh fund's recently disclosed portfolio holdings, for each fund. At least 80 percent of the total assets of the proxy will overlap with the fund.
  • Low Turnover of Proxy Basket. While the adviser may change the proxy at any time, the expectation is that change would be made quarterly.
  • Smaller Creation Unit Size. Minimum creation unit size will be lowered to 5,000 shares.

What is Fidelity’s semi-transparent active structure? 

Fidelity’s proxy, referred to as the Tracking Basket, will consist of underlying fund holdings, ETFs, and cash. The Tracking Basket will be derived through a proprietary optimization process. The overlap between the fund and the Tracking Basket will be published to the fund’s website daily.

Fidelity
  • Tracking Basket. Fidelity proposes to publish daily a Tracking Basket, that will only consist of underlying holdings, representative ETFs (capped at 50 percent), and cash or cash equivalents.
  • Optimization. The Tracking Basket will be calculated through a propietary optimization process that will seek to minimize the tracking error, turnover cost, basket creation costs between the fund and tracking basket. Each day prior to market open, the fund will disclose the overlap between the tracking basket and fund.  

What is Blue Tractor Shielded Alpha?

Blue Tractor’s Shielded Alpha℠ will disclose the securities that are in the actual fund each day, but will not provide their individual weightings. Each day a proprietary algorithm will generate a portfolio that has at least 90 percent overlap with the fund’s portfolio.

Blue Tractor Shielded Alpha
  • Proprietary Algorithm. The Dynamic Stoc Specific (SSRSM) Portfolio will shield the strategy of the portfolio manager, while only including the same holdings as the fund at different weights. The deviation in security weights between the fund and the proxy will have a publicly disclosed cap.
  • Proprietary Licensing. Blue Tractor said it will license the software to fund advisers who want to bring to market proprietary active strategies wihin the Shielded Alpha ETF wrapper.
  • Smaller Creation Unit Size. Minumum creation unit size will be 5,000 shares.  

New “Semi-Transparent” Product Structures

Structural Features
Traditional ETFs
Traditional MFs
Active SharesTM
Proxy*
Subject to Premium/Discount X   X X
Intraday Market-Based Pricing X   X X
End-of-Day NAV Based Pricing   X X X
Limit Orders X   X X
Tax-Efficiency X   X X
Use of In-Kind Transactions X   X X
Spreads X   X X
Daily Fund Holdings Disclosure X None Limited Distribution Proxy Basket
Unlimited Intraday Trades X   X X
*Natixix/NYSE, T.Row Price, Fidelity, Blue Tractor

Considerations for Managers

These product structures may be ideal for an asset manager who is managing active strategies and is wary of publishing their holdings daily. When considering whether these products are right for their firm, managers should ask themselves:

  • Which product structure is right for my strategy?
  • How will I price these products alongside my existing investment menu?
  • Should I seek to replicate existing strategies or launch something new?
  • Will broker/dealer platforms support these products?
  • What are the operational nuances that are unique to these products?
  • How will I need to adjust my distribution strategy to support these products?
  • How should I structure my capital markets team to support these products?

Asset managers should consider what strategies may work in this wrapper and how a proxy-basket, semi-transparent active offering could be added to their capabilities. BBH is ready to discuss these products in more detail and welcome the opportunity to engage with firms in deeper dialogue about this development.

Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers and sponsors to bring ETFs to market in the US, Europe, and Hong Kong. BBH has worked with all four proxy product sponsors and other third-party providers to design an operating model to service these products. 

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2021. All rights reserved. IS-05744-2019-12-11

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