Active ETFs With Special Risks

If the U.S. Securities and Exchange Commission (SEC) says no, keep trying. This seemed to be Precidian Investments’ motto, and its persistence appears to have finally paid off. The firm received approval for its new kind of exchange-traded fund (ETF). The approval came after years of being sent back to the proverbial drawing board. The firm describes its efforts as “a struggle that has been ongoing for the better part of a decade.”

Precidian intends to launch nontransparent active ETFs, branded ActiveShares. These are ETFs whose assets will only be disclosed on a quarterly basis. In contrast, ETFs currently disclose their holdings daily. Daily disclosure has been a hurdle for many active managers who fear having traders jump ahead of their trading decisions if their portfolios are made known.

Most mutual funds only disclose their holdings on a quarterly basis. Shares of mutual funds are bought and sold based on the end-of-day value of their underlying holdings. When you spend $1 to buy a share (or a partial share) of a mutual fund, you get $1 of assets based on their end-of-day value. This is not the case with nontransparent ETFs, which trade throughout the day. When you spend $1 on a nontransparent ETF, you may get $1 worth of assets, you may get more than $1 worth of assets or you may get less than $1 worth of assets. You simply won’t know.

The reason why has to do with how ETFs are different than mutual funds. When you buy or sell mutual fund shares, the money goes into/flows out of the mutual fund’s assets. Shares of ETFs are bought and sold among investors on the open market; the money does not go into or out of the ETF itself. An intermediary, known as an authorized participant (AP), corrects imbalances by not only trading in the open market, but also by transacting in creation units with ETF providers. Creation units are blocks of generally 50,000 shares that can be exchanged for a basket of the underlying securities and cash. The exchange of creation units is enabled by the daily disclosure of an ETF’s holdings. APs can identify what is held by the fund and, based on that information, determine whether the ETF’s shares are trading at a premium or a discount. This transparency allows most ETFs to trade close to their net asset value (NAV) under normal market conditions. (ETFs investing in less frequently traded assets and/or following more esoteric strategies may still trade at premiums or discounts to their NAV even with full transparency.)

In the case of Precidian’s ActiveShares, rather than knowing what the ETFs actually hold, the APs will confidentially be informed of a “verified intraday indicative value,” or “VIIV.” In its SEC filing, Precidian asserted that the “VIIV will be an accurate representation of the value of a fund’s portfolio securities.” Though updated every second, it’s not the NAV of the fund nor is it clear how accurate the VIIV will be in practice. Reuters say the SEC twice rejected Precidian’s proposals before accepting this revised version.

If some of you are thinking this all sounds familiar, it’s because Precidian is not the first firm to push nontransparent ETFs. Eaton Vance’s NextShares previously received the green light to launch nontransparent ETFs. So far, their funds have not attracted much in the way of investor dollars. Thirteen of the 14 NextShares funds currently in existence have less than $15 million in assets under management (AUM). This is a very small number. Even transparent actively managed ETFs have mostly failed to attract much investor attention. There a few exceptions, such as PIMCO Active Bond ETF (BOND) with its $2.1 billion in AUM, but they are the outliers.

There is also the record of active management to take into account. After fees are considered, the majority of active managers don’t beat their index. Though some do, picking which ones will do so in advance is very difficult.

While much is made about the advantages of being a first-mover, there is often a disadvantage to being one. The ActiveShares ETFs are one such case where patience is the better strategy. These are new types of funds and it is very uncertain how they will actually perform in the real world. The reward from good investments occurs over time, not at launch.